A Post-Gloom Glimmer of Hope for Bond Investors

Meanwhile, back at the bond market, the third quarter provided a glimmer of hope for beleaguered bond fund investors--a glimmer that took on much greater wattage Friday with the surprisingly weak September employment report.

Bond yields tumbled Friday, continuing their recent slide on growing expectations that the economy is finally decelerating from the brisk pace of spring and early summer.

The bellwether 30-year Treasury bond yield ended at 6.74%, the lowest since Aug. 12 and down from 6.89% on June 30. Shorter-term yields have also sunk in recent weeks.

The trend toward lower rates was strong enough in September to give most bond fund investors positive total returns in the third quarter. In other words, because market interest rates ended the quarter near the same level or below where they began, the principal value of older, fixed-rate bonds was unchanged or higher--so you earned your interest and maybe more.

Funds that own long-term Treasury bonds, for example, posted a positive total return of 1.52% for the quarter, on average, according to Lipper Analytical Services. Those funds had suffered a negative total return of 2.62% for the first half of the year, when rising market rates devalued the principal value of older bonds.

While Treasury bond fund investors had to be content with modest returns in the third quarter, other bond sectors were on fire. Investors were on a hunt for high yields, and they found them in Third World bonds (so-called emerging-market debt), U.S. corporate junk bonds and, to some degree, tax-free municipal bonds.

Emerging-market bond funds zoomed 12.9% in the quarter, on average, counting interest return and gain in principal value. Junk bond funds shot up 4.7% on average.

Many Wall Street pros say a large number of bond investors are acting more like stock investors: They are increasingly willing to take higher risk to get high returns.

The junk bond market, meanwhile, has also benefited because many of the higher-risk companies behind those bonds have dramatically improved their balance sheets by raising capital in the runaway stock market this year.

The big question now: Will investors’ willingness to take more risk push them into long-term Treasury bonds and high-quality corporate bonds in the fourth quarter, on the bet that the economy is slowing enough to provoke a steep decline in long-term yields overall?

The Federal Reserve Board, by opting not to tighten credit at its Sept. 24 meeting, appears to have had it right, many Wall Streeters concede. Stephen Roach, a Morgan Stanley & Co. economist who had been expecting higher interest rates, told clients Friday: “In the eyes of investors, the economy is soft, inflation is dead and a passive Fed has won a major credibility battle. Barring the low-probability outcomes of a sudden surge in the real economy or an unexpected flare-up on the inflation front, this bullish sentiment seems likely to persist for longer than we had been thinking.”

Scott Grannis, economist at Western Asset Management in Pasadena, says the September employment report is no fluke, but rather a confirmation of other data showing that the economy is indeed slowing. He thinks it will slow enough to drive the 30-year Treasury bond yield to 6% again by year’s end.

If he’s right, the dismal year-to-date total returns on most bond funds should improve markedly in the fourth quarter, as principal values appreciate in the face of lower market rates.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

How Bond Funds Fared

Here are average total returns for key categories of bond mutual funds for three periods ended Sept. 30. Total return includes interest earnings plus or minus any change in the bonds’ principal value.

Emerging market bonds: Average total returns for

3rd Qtr.: +12.89%

9 mos.: +29.8%

5 yrs.: NA

*

Junk corparate bonds: Average total returns for

3rd Qtr.: +4.66%

9 mos.: +9.8%

5 yrs.: +80.0%

*

Multi sector inc: Average total returns for

3rd Qtr.: +4.37%

9 mos.: +7.6%

5 yrs.: +60.2%

*

Global bonds, long term: Average total returns for

3rd Qtr.: +3.98%

9 mos.: +6.0%

5 yrs.: +42.3%

*

Mixed bonds: Average total returns for

3rd Qtr.: +2.63%

9 mos.: +2.5%

5 yrs.: +56.5%

*

Calif. muni bonds, long term: Average total returns for

3rd Qtr.: +2.57%

9 mos.: +1.1%

5 yrs.: +39.6%

*

General muni bonds, long-term: Average total returns for

3rd Qtr.: +2.27%

9 mos.: +0.8%

5 yrs.: +40.0%

*

Lower-quality corporate bonds, long-term: Average total returns for

3rd Qtr.: +1.99%

9 mos.: -0.3%

5 yrs.: +51.2%

*

GNMA bonds: Average total returns for

3rd Qtr.: +1.89%

9 mos.: +0.9%

5 yrs.: +36.8%

*

High-quality corparate bonds, 5- to 10-year: Average total returns for

3rd Qtr.: +1.78%

9 mos.: +0.3%

5 yrs.: +40.2%

*

High-quality corparate bonds, long-term: Average total returns for

3rd Qtr.: +1.72%

9 mos.: -0.6%

5 yrs.: +42.8%

*

High-quality corparate bonds, 1- to 5-year: Average total returns for

3rd Qtr.: +1.58%

9 mos.: +2.8%

5 yrs.: +31.9%

*

U.S. govt. bonds 5- to 10-year: Average total returns for

3rd Qtr.: +1.56%

9 mos.: +0.7%

5 yrs.: +34.6%

*

U.S. govt. bonds, long term: Average total returns for

3rd Qtr.: +1.52%

9 mos.: -1.1%

5 yrs.: +36.0%

*

U.S. govt. bonds, 1- to 5-year: Average total returns for

3rd Qtr.: +1.47%

9 mos.: +2.5%

5 yrs.: +29.5%

*

Money Market: Average total returns for

3rd Qtr.: +1.18%

9 mos.: +3.6%

5 yrs.: +21.4%

* Source: Lipper Analytical Services Inc.