Bonds battered by worry

Bond funds were a generally dreary place to be in the first quarter.

As the credit crunch intensified, forcing up yields on a wide range of debt securities, many categories of fixed-income funds lost money in the first three months of 2008.

Some sectors normally prized for their credit quality, such as municipal bonds, were hit hard. And if you were invested in bank-loan or ultra-short-term funds -- well, you got pummeled.

So if you view bond funds as a hedge against a decline in the stock market, it might be small comfort that they didn’t lose as much money as the average equity fund, which dropped more than 10% in the quarter.

“It was remarkable how messed up the bond market was in the first quarter,” said Kent Wosepka, manager of the Dreyfus Intermediate Term Income fund. “Just about everything not only did poorly but in many cases did so in a less than rational way.”

Treasury portfolios did well -- though not as spectacularly as in the fourth quarter -- as investors fleeing riskier bonds and stocks holed up with government securities.

The problem was that so many people crowded into the Treasury market, yields fell to unattractive levels, raising the question of where to put your money next.

Long-term Treasury funds notched an average total return of 4.4% in the first quarter, according to tracker Morningstar Inc. Intermediate-term Treasury funds rose 2% while short-term Treasury portfolios climbed 2.1%. Inflation-protected bond funds gained 4.8% as prices showed signs of accelerating.

Total return includes changes in the market value of a fund’s holdings plus its interest income.

Also benefiting from the rush to safety were so-called world bond funds, which invest heavily in obligations of foreign governments. Those funds, which also were helped by a declining dollar, returned 5.2% in dollar terms.

Government funds, however, were the exceptions.

For the most part, bond funds avoided huge blow-ups, largely because their holdings of sub-prime mortgage securities were limited. But the market value of nearly every bond category outside of Treasuries fell.

High-yield, or junk, funds skidded 3.6%, while the average corporate bond fund lost 1% and emerging-market bond funds were 0.1% in the red.

Many sectors came under selling pressure.

Numerous hedge funds and other highly leveraged institutional investors had to raise cash as the value of their holdings of highly rated mortgage-backed securities unexpectedly slid.

Among the worst performers were ultra-short-term bond funds, which dropped 2%, and bank-loan funds, which sank 6%, the worst quarterly showing since Morningstar began tracking the category in 1999.

“It was a quarter of extremes,” said Morningstar analyst Scott Berry.

Ultra-short funds were hurt by several factors, including exposure to lower-quality bonds and a heavy weighting in beaten-up finance-sector bonds, Wosepka said.

The category’s overall performance was skewed by big losses at a few funds. The Schwab YieldPlus fund skidded 19.9%, and the Fidelity Ultra-Short fund fell 6.9%.

But more than half of the 49 ultra-short funds fell in value, according to Morningstar.

The sector’s woes have been exacerbated by heavy redemptions, which has forced managers to sell into a weak market.

“It’s supposed to be one of the safest areas, but certain funds -- including Schwab, Fidelity and a few others -- got slammed in the first quarter,” Berry said. “They were just shocking losses. There’s no other way to say it.”

The picture was equally grim in bank-loan funds, for many of the same reasons.

These funds buy loans made to troubled companies. The funds were thought to be relatively safe, in part because they take precedence over junk-bond holders in bankruptcy filings.

But loan values fell sharply as investors shunned risk. All 30 bank-loan funds tracked by Morningstar lost money in the first quarter.

Municipal-bond funds also had a weak three months, primarily because of intense selling in February by investors worried about the financial condition of companies that insure muni bonds.

Funds holding long-term California muni bonds lost 1.9%, according to Morningstar.

Muni prices rebounded in March as buyers snapped up bargains.

But there’s still the chance to get good deals in muni funds, with yields unusually high relative to Treasuries, some experts say.

“There are tremendous opportunities,” said Meloni Hallock, chief executive of Acacia Wealth Advisors in Beverly Hills. “The spreads are really quite amazing in some cases.”

Joe Balestrino, a fixed-income strategist at Federated Investors in Pittsburgh, said his firm had lately been buying corporate bonds on the assumption that they’ll rise in value as the economy rebounded.

That might not happen right away -- and corporate prices could slide if the economy softens further -- but he’s buying now. “We want to catch the first wave because it can be powerful,” he said.

But if fear of more market turbulence has you thinking about getting into Treasury funds, or staying in the ones you own, you might want to think again, many experts say.

Not only is the sector offering puny yields, but you also could suffer when the economy and financial markets stabilize.

Investors who have stampeded into Treasuries for safety could rush out in favor of stocks or riskier bonds.

“There’s no protection in the Treasury market,” Balestrino said. “Give yourself exposure to the non-Treasury sectors.”

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walter.hamilton@latimes.com