Bond Funds Thrive Amid Uncertainty

Fixed-income mutual funds continued to hold their own against stock funds in the third quarter, despite a September surge in interest rates.

“The planets were in alignment for bond fund investors this quarter,” Edward S. Rosenbaum, director of research for fund research firm Lipper Inc., wrote in a report last week. “The Fed, the economy and uncertain investors were all pointing in the same direction.”

The average government bond fund delivered a total return--interest payments plus or minus any change in the principal value of the underlying bonds--of 2.5% in the third quarter ended Sept. 29, according to Morningstar Inc., another mutual fund research firm. For the year through September, the average government bond fund had returned 6.1%.

By comparison, the average U.S. equity fund gained a meager 2.6% in the quarter, according to Morningstar, and was up 6.3% through the first nine months of the year. That’s a far cry from the double-digit gains stock investors have come to take for granted in recent years.

Fixed-income funds turned in a strong performance in spite of a rocky September, when a sharp spike in oil prices and the near-collapse of the euro combined to push up interest rates. Concerns over the future of the federal budget surplus--fanned by presidential campaign promises of massive tax cuts and spending programs--didn’t help.

The situation eased when President Clinton ordered the release of oil from the national petroleum reserve and European central bankers moved to prop up their beleaguered common currency.

Among the various sectors, funds that invest in the debt of emerging-market nations led the pack with a 3.4% total return in the third quarter, as several developing nations reported positive financial results. This category is now up more than 10% for the year--handily outperforming the average U.S. stock fund.

At the other end of the scale were funds that buy bonds issued by developed nations. As a group, international bond funds limped home with a loss of 1.4% in the quarter. Weakness in the euro and the yen against the dollar was a chief culprit. As these currencies depreciated, the returns of American investors declined accordingly when they were converted into dollars.

Government bond funds performed well during the quarter across the yield spectrum, ranging from a total return of 2.7%--9.4% year-to-date--for long-term government funds to 2.1% for short-term funds. Analysts said Treasuries benefited from a classic “flight to quality” as investors sought shelter from an equity market wracked by profit warnings and crumbling Internet stocks.

Funds that invest in tax-exempt municipal bonds, meanwhile, benefited from declining yields on long-term government bonds, which made longer-term munis more attractive to investors. Long-term California muni funds turned in a total return of 3.1% for the quarter and 8.1% year-to-date.

Corporate bond funds also enjoyed a rewarding quarter as investors absorbed several multibillion-dollar issues by corporate borrowers such as Banc One, Ford Motor Credit and Qwest.

The only setback for U.S. bond funds was in the sector that invests in junk bonds--also known as high-yield bonds. These bonds offer higher yields but are also riskier than blue-chip corporate securities. Analysts said junk bonds suffered from the general aversion to speculative investments that characterized the third quarter.

The junk bond fund category lost 1.2% in the quarter, according to Morningstar, and is now down 3.0% for the year. And the situation isn’t getting any better. Since early September, junk bond yields--which move in the opposite direction of the bonds’ prices--climbed from 10.70% to 11.25%, according to the KDP High Yield Daily index.