July 3, 2002

High-Quality Bond Funds -- Mid-Year 2002 Review

The Struggle for Modest Returns

July 3, 2002 -- Against a backdrop of corporate scandal, declining short-term interest rates, a weakening dollar and a lackluster economy, the average high-quality bond fund eked out a total return of barely over 2% for the first half of 2002. For managers whose funds beat the average, the right calls made all the difference.

Funds whose holdings included large doses of government bonds, especially some of the agency bonds, such as Fannie Maes and Freddie Macs, found their holdings rise in value as nervous investors, wary of corporate bonds, bid up prices in the quest for safety.

Placement on the yield curve was also important as short-term rates went down and longer-term rates edged up. Todd Ahlsten, who helps manage the Parnassus Income Trust Fixed Income Fund (PRFIX), an intermediate bond fund, credits the fund's average duration of about seven years as having a significant role in the fund's 3.7% return for the first half. Other factors included significant holdings in government agency issues and rallies in some undervalued corporate bonds.

And similar to the equity markets, funds of managers who look for value bubbled up to the top. A case in point is Loomis Sayles Inv Tr Investment Grade Fixed Income (LSIGX), which managed an outsized return of 6.4% for the first half of 2002 by finding undervalued credits, especially in foreign currencies.

Xavier Urpi, co-manager of the Accessor Funds:Intermediate Fixed Income Fund (AIFIX), thinks the team's correct calls on bond quality and sector bets, starting in the middle of last year, were significant in helping the fund achieve a return of 5.4% for the period through June 28. The fund has avoided technology altogether; and, anticipating a weak economy in 2002, the managers decided to overweight high-quality credits in strong sectors such as utilities and financial. Urpi also thinks that positioning the fund's holdings between five- and 10-year maturities paid off in the first half.

Although none of the fund managers we talked to is predicting higher rates as the year progresses, there appears to be general agreement that short-term rates have bottomed, and that a rate increase, while unlikely, is possible if the economy picks up. Fears about corporate wrongdoing, not the Fed, will roil the bond markets as the year progresses.

A common response in anticipation of this turmoil is to shorten duration, reducing exposure to rate changes. Parnassus Fund's Ahlsten has already sold off some of the fund's longer-maturity bonds and, uneasy about the consumer, has put the auto sector into short-term securities.

Where do we go from here? For a value fund like Loomis Sayles Investment Grade, finding new ideas that are similar to the fund's existing value holdings at a period when rates are a lot lower is the hard part, says a spokesman for the fund manager. Dan Fuss, who has steered the portfolio since July 1994, continues to bet on foreign currency gains with new credits from Samsung Electronics and some additions priced in New Zealand dollars. By looking for value, Fuss thinks he won't be much worse off even if market conditions deteriorate, but he could be a lot better off if conditions improve.

For Kelly Johnson, of PIMCO Total Return II Fund (PRADX), who managed a respectable 3.9% return for the first half, the beaten-down telecom sector is beckoning. He thinks values can be found in issues from AT&T and Sprint and in German bonds, which offer high quality and the prospect of currency gains.

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