Bond funds roll on despite rate-hike warnings

After beating stock funds for three years in a row, bond funds fell behind in 2003.

The average general bond fund gained 6.9 percent last year, according to mutual-fund tracker Lipper Inc. Not bad, except in comparison to the performance of the Standard & Poor's 500 stock-market index, which jumped 26 percent.

"It's actually been a decent year for the bond market," says Scott Berry, senior analyst at Morningstar Inc. in Chicago. "Coming into the year, a lot of investors feared rising interest rates and thought bonds were going to struggle to break even."

Early in the year, however, the United States' economy remained sluggish as concerns over the war in Iraq, threats of terrorism, and a weak labor market kept a lid on growth. But by midsummer, it became clear the economy was recovering. As a result, Mr. Berry says, "the corporate-bond market has had a big rally and that has lifted most diversified bond funds and helped them post decent gains."

But some of the ingredients that contributed to a decent year for bonds in 2003 may not appear in 2004, analysts say.

"The improving economy, the large and growing fiscal deficit, and the balance-of-trade deficit are laying the foundation for rates to rise in 2004," William Reynolds, director of the fixed-income division at T. Rowe Price, wrote in a year-end report.

"Bonds don't have a whole lot of place to go," agrees Gina Sanchez, co-lead portfolio manager for three American Century strategic-allocation funds. "We've seen four years of a bull market in bond-land. The best situation would be for bonds to stay where they are, but the market is pricing in a rate rise this coming year."

As interest rates rise, values of existing bonds drop. On the other hand, higher rates could mean more income for investors who get regular payments from bond funds. In fact, investors who saw big gains from stocks last year might reallocate some of those profits into bonds, says James Pinney, a financial planner in Cambridge, Mass. This would have a double benefit: the possibility of a little more income and a portfolio that's more broadly diversified.

Two types of bond funds - the high-yield and emerging-market sectors - did perform well in 2003. Both returned over 25 percent for the year. High-yield bonds are often the first to benefit from an economic recovery. At the same time, several emerging-market nations made economic and political reforms that made their debt more attractive to investors. Historically low rates on US government bonds also played a role as investors turned to riskier emerging- and high-yield markets for greater returns.

Over the past few months, however, high-yield bonds have faltered, shrinking their advantage over less risky investment-grade corporate bonds. "We've seen yields on high-yield bonds come down quite a bit, more to their historical levels, so the capital-appreciation potential may not be there going forward," Berry says. But if the economy continues to do well and firms continue to meet their debt payments, these funds could still provide decent income. "I don't see these funds having a year like 2003, but investors may be able to earn their yield, which may be 6 to 8 percent," he says.

Finally, Berry thinks the municipal-bond market - in spite of the financial straits of many states - is in pretty good shape. "If you look at the national municipal-bond funds, you see returns ranging from 4 to 5 percent for the year, which is pretty good for a municipal-bond fund."

Low rates have helped keep borrowing costs down for cities and states, he notes, while several states have worked hard to address budget problems. "California, of course, has problems, but other states have made a lot of progress," he says.