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Get to know bond funds
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June 29, 1999: 6:15 a.m. ET
Despite bear market, you should not overlook bond funds, experts say
By Staff Writer Martine Costello
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NEW YORK (CNNfn) - Bond fund manager Robert Rodriguez is not worried that bonds are in the grip of a bear market with teeth. He has seen worse.
Once he even received a "Dear John" letter from an investor during the granddaddy of all bond bear markets in 1994. But through them all, his fund has eked out positive returns.
"I've been in this business for 30 years, and there have been a lot of 'worst' periods," said Rodriguez, manager of the FPA New Income Fund. "Like Yogi Berra said, it's deja vu all over again."
Bond funds are getting more attention these days as many Wall Street pros say stocks are overvalued. And with yields at record highs (yields move in the opposite direction of prices), managers say this is a good time to put money into bond funds.
"A bear market is the time to be buying bonds," said John Woolway, manager of the First Omaha Fixed-Income Fund.
Bond fund suffering
The yield on the 30-year bond moved as high as 6.19 percent last week on worries that the Federal Reserve will raise interest rates more than the expected 25 or 50 basis points. The long bond on Monday had rallied somewhat and was trading at a price of 88-13/32 for a yield of 6.10 percent. Fed policy-makers meet Tuesday and Wednesday.
"Right now, the sentiment is very negative," said Greg Habeeb, manager of the Calvert Income Fund. "I wish (the yield) peaked. I fear it hasn't."
Habeeb doesn't think yields will hit 7 percent, while Rodriguez thinks they might touch 6.5 percent.
Most bond funds have been hard hit by the downturn, said Eric Jacobson, a bond fund expert and analyst at Morningstar, a Chicago fund-tracker.
Worst hit were long-term government bond funds, off 4.6 percent year to date as of May 31; international bond funds, down 3 percent in the same time; long-term bond funds, down 1.5 percent, and intermediate bond funds, in the red by 1.4 percent.
"It's fair to say that most of them have lost money," Jacobson said.
That makes the winners all the more remarkable, he said. For example, the Calvert fund is up 4.75 percent year to date as of May 31, while Rodriguez's fund earned 2.62 percent in the same time.
Only 35 funds in the intermediate bond fund category broke even or earned a profit in the first five months of the year, according to Morningstar data. Woolway's fund wasn't so lucky. The fund, in the same category as the Calvert fund and the FPA fund, was down 3.45 percent in the same time.
"We're not going to change our investing style just because interest rates have moved," Woolway said. His fund, which invests about 70 percent in longer-term corporate debt, profited by staying true to its style in the past. For example, Woolway stayed firm during the 1994 downturn and was able to earn 20.43 percent the following year.
Funds that did well last year by capitalizing on low yields took on more risk by investing in longer-term bonds that are more interest-rate sensitive, Jacobson said. Funds that didn't take on that extra risk, like Rodriguez's, are doing better this year.
Jacobson said the top-performing categories for the first five months of the year were emerging markets, up 6.21 percent; convertible bonds, up 6.06 percent; high yield, up 3.16 percent, and ultra-short bonds, up 2.05 percent.
Jacobson warned that emerging-market bonds can be extremely volatile. In April alone, the funds dropped an average of 6 percent, he said.
But Jacobson said convertible bond funds, which invest in debt that has an option to convert into stock, can deliver big gains. For example, if there's an option to buy a company's stock at $30 but the shares are trading at $90, it can spell big profits. Many Internet companies have been looking to the convertible bond market, so it can be a safer way for an investor to buy Amazon.com (AMZN), Jacobson said.
Another big winner is the segment called inflation-indexed bond funds, Jacobson said. While only a few of them exist, they have leapt to the top of their categories because the value of the bonds gets adjusted upward to account for inflation.
One inflation-indexed bond fund, the American Century Inflation Adjusted Treasury Bond Fund, is second for top returns among all intermediate government funds, up 1.56 percent year to date through May 31.
Rodriguez said his fund's portfolio is about 37 percent inflation index bonds.
Short-term bonds were also top performers because they are the least sensitive to interest rates, while long-term bonds are the most sensitive and therefore risky, Jacobson said.
What should investors do?
Most investors have ignored bond funds since their heyday in the mid-1980s, preferring to invest in individual bonds, Jacobson said in a recent analysis.
"Given the depth and complexity of the bond market, as well as its numerous inefficiencies and opportunities, bond funds deserve a lot more attention from individual investors," Jacobson wrote.
Investors who are in the bond market have looked no further than individual government bonds, or government bond funds, which are extremely sensitive to interest rates, Jacobson said.
"A good bond fund, like a high yield fund, has less credit risk and less interest rate risks -- and a good manager will add value," Jacobson said.
People who do not have any money in the bond market should start with an inflation-indexed bond fund, Jacobson said. Another good choice is an intermediate bond fund that invests in some corporate debt and some government bonds.
"Conventional wisdom is you don't need too many bond funds," Jacobson said.
Jacobson said he is a big fan of high-yield bond funds because they deliver a generous yield but have the benefits of investing in debt. Plus, a good manager can take advantage of existing inefficiencies in the high-yield market to add more value, he said.
"You want to understand why a bond manager makes certain strategic decisions," Jacobson said.
Anybody who thinks they do not need bond funds should think again, Jacobson said.
"It's easy to say, 'Throw it all in stocks,' " Jacobson said. "A lot of people say that, but they've never been through a bad bear market."
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