In defense of bond funds: why these investments remain easy to love, even as interest rates settle lower and lower

Kiplinger's Personal Finance Magazine, August, 1998 by Steven T. Goldberg

Why these investments remain easy to love, even as interest rates settle lower and lower.

Are you consumed by guilt over your Dirty Little Secret? you ache to unburden yourself, but hold back for fear of ridicule? There's no reason to live like this. Repeat after us, in a joyful voice: Yes, I own bond funds. And I'm proud of it, too!

There. You did it. The stock-fund bullies had tormented you. They told you that over the past five years Standard & Poor's 500-stock index nearly tripled, while the Lehman Brothers Aggregate Bond index returned 41%. That really hurt. And they:reminded you of this: Since 1926, stocks of large companies returned an annualized 11%, while long-term corporate bonds climbed only an annualized 5.7%. Or the real killer of your self-confidence: Truly long-term investors, those with a time horizon of more than ten years, can forget all about bonds.

Now stop being so defensive. Bond funds are perfectly appropriate even in a long-term portfolio. Here is the case for owning bond funds in 1998--good reasons why bonds are relevant today, along with funds that exemplify those reasons.

First, stocks are riskier. As measured by the S&P 500, stocks delivered more than twice their average historical returns over the past five years with hardly a hiccup. Historically, bear markets (stock-market declines of 20% or more) occur about once every five years, so we're three years overdue. By contrast, long-term corporate bonds have never lost more than 8.1% in a calendar year. Moreover, bonds and stocks don't always move in the same direction. In mid June, for instance, stocks sold off sharply even while yields on 30-year Treasury bonds hit record lows and prices soared. Bottom line: A bond fund adds stability to your investments.

In choosing a bond fund, your best bet may be a widely diversified one that invests in many sectors of the bond world. One such fund is Loomis Sayles Bond. We've called Daniel Fuss the best bond picker in America simply because the 64-year-old manager's fund has consistently ranked in the top 10% among all bond funds (along with above-average yields from income), His method is simplicity itself: Fuss buys bonds when he perceives them to be even slightly undervalued, and sells them when their prices rise in line with similar issues. For instance, he has used Asia's woes to load up on Korean and Thai bonds. The fund has about one-third of assets in low-quality bonds, mostly foreign issues. Fuss has a record of tiptoeing around trouble, such as during periods of rising interest rates, which trip up most other funds heavily invested in long-term bonds. The fund's recent 30-day yield was 7.4%.

T. Rowe Price Spectrum Income is another top-performing diversified fund. It invests in nine other T. Rowe Price bond funds, charging investors only the expenses of the underlying funds. Besides U.S. bond funds, it has 2.5% of assets in volatile Emerging Markets Bond, 7% in International Bond and 14% in Equity Income, a stock fund. Yet Spectrum Income is less volatile than the Lehman Brothers Aggregate Bond index. A committee of eight decides how much to put into which funds. "We don't make any large bets," says co-manager Ned Notzon. Spectrum Income's weighted average maturity is 9.5 years--less than half that of Loomis Sayles Bond--yet like the Loomis fund it has finished in the top 10% over the past three and five years. Its 30-day yield is 6.1%.

YIELDS ARE HIGH

How can that be, when few bond funds can deliver more than 5% to 6%? With inflation running below 2% annually, the after-inflation yield is above its historical norm. Since 1926, bonds have returned only an annualized 2.3% after inflation, according to Ibbotson Associates. Jim Paulsen, chief investment officer of Norwest Investment Management, thinks locking in today's high after-inflation yields is smart. He predicts inflation will drop to near zero and that the yield on 30-year Treasury bonds (recently about 5.6%) will fall below 5.25% this year and below 4% in a few years. That would give bond-fund investors a healthy dose of growth in addition to yield.

Because their interest income is not subject to federal income tax, municipal bonds have traditionally yielded less than Treasury issues of comparable maturity. But 30-year munis now offer around 90% of the yield of a Treasury bond. Even if you're in the 15% tax bracket, a muni bond's after-tax yield will be greater than that of a Treasury. Here are two different municipal-bond funds:

Strong High-Yield Municipal Bond fund yields a rich 5.5% in tax-exempt income because it invests in low-quality bonds, which tend to suffer when the economy weakens. Among its peers over the past three years, the Strong fund ranks first in total return. While touring assisted-living centers recently in Asheville, N.C., manager Mary-Kay Bourbulas told staffers she was looking for a place for her mother to live. In fact, she was checking into possible investments. When you buy bonds of less creditworthy issuers, she says, the number-one rule is, "Don't buy without looking--visit everything."