Bonds look a bit winded after last year's bull run

Burned yet again by stocks, mutual-fund investors who turned to the relative safety of the bond market in 2002 were rewarded with strong gains.

It was the third consecutive year in which debt securities outshone stocks - the first time that's happened since 1939-41.

Adding interest payments to bond-price appreciation, the 2002 "total return" was 10.2 percent for a broad bond index tracked by Lehman Bros. The benchmark Standard & Poor's 500 stock index, meanwhile, suffered a negative total return of 22.1 percent.

But not all was perfect in the fixed-income universe last year, and some experts are seeing signs that bonds may soon lose their luster.

"We've been spoiled for the past three years," says Mark Kiesel, a senior portfolio manager at PIMCO Funds in Newport Beach, Calif., the nation's largest group of bond mutual funds. Mr. Kiesel figures about 6 percentage points of last year's average bond fund returns were due to the effect of falling interest rates on bond prices. "But," he warns, "now the bull market's over."

Analysts are especially cautious about longer-term bonds, whose prices could plunge the most if rates rise.

Here's a closer look at the performance of the various bond mutual-fund sectors last year, and the outlook for 2003.

Treasuries: Reacting to the sluggish economy, corporate scandals, and threats of war, investors seeking safety flocked to US government securities. Funds holding long-term Treasuries rose 13.2 percent for the year on average, according to Morningstar Inc. Even short-term US government funds were able to notch an average total return of 6.6 percent, according to Morningstar.

But after the big run-up last year in demand and prices, the consensus among analysts is "anything but Treasuries," said Eric Jacobson, a senior bond analyst at Morningstar. Assuming the economy continues to recover, "The real question isn't if rates will rise, but when, and by how much and for how long," he said.

Investment pros who still favor Treasury securities, however, say market rates could go even lower if the economy stumbles again.

Municipals: The total return on funds that invest in long-term, tax-free municipal debt nationwide averaged 8 percent in 2002, according to Morningstar. Although he doesn't expect muni funds' hefty returns of 2002 to continue this year, Kiesel says PIMCO still regards munis as good buys, compared with Treasury securities.

Gary Larsen, a senior vice president of US Trust who manages the Excelsior California Tax Exempt Income Fund, advises clients not to chase the longest-term municipal bonds and muni funds. "I'd rather be in a five-year at 2.25 percent right now than in a 30-year at 5 percent," he said, "because the 30-year muni could be worth 50 or 60 cents on the dollar very quickly" if the economy takes off and interest rates rise.

A word of caution: The place for muni bonds and the funds holding them is in taxable accounts, not retirement accounts in which earnings already grow tax-free or tax-deferred.

Corporates: Despite meltdowns in energy and telecom company bonds, there was money to be made in higher grade corporate debt last year. Funds investing in long-term investment- grade corporate bonds recorded an average total return of 8.6 percent in 2002, says Morningstar.

Mr. Jacobson says funds holding corporate bonds won't be hurt as much as those in Treasuries if a strengthening economy pushes rates higher, because a stronger economy also should make defaults by corporate issuers less likely.

Corporate bonds at the lower end of the investment-grade ratings and in the junk category presumably would benefit most from economic strength. A rise in a company's profit could lift its credit ratings and boost the price of its bonds.

Foreign: Whether US investors should dabble in foreign bond funds is a matter of debate among analysts, because foreign funds' performance involves many complex factors.

Still, there is no doubt that the often volatile funds can present opportunities. International bond funds turned in an impressive performance last year, with a total return averaging 13.6 percent, according to Morningstar.

And the relative handful of funds that focus on emerging-markets countries' debt rocketed 13.3 percent in the fourth quarter.