High-Quality Bond Funds -- Mid-Year 2005 Review

Bonds Hang Tough

As the U.S. economy appears to be on solid footing, with inflation in check, consumer confidence picking up, and short-term interest rates still at relative low levels, high-quality bonds delivered modestly good results through the first half of 2005, performing nicely in the second quarter.

The average high-quality corporate bond rose 1.5% over the first half of the year, while the average government securities fund edged down 0.07%. In the second quarter, the average high-quality corporate bond fund rose 2.4% and the average government bond fund gained 2.7%.

One peculiar wrinkle on bond markets, however, has been what Federal Reserve Chairman Alan Greenspan has described as a "conundrum:" the fact that as short-term rates have risen due to Fed tightening policy, long-term rates have inexplicably remained flat, or even decreased. Long-term Treasury bonds have delivered the strongest returns among this sector year-to-date. They also assume more risk.

Cathy Roy, chief investment officer for fixed income at the Calvert Group, explained that long-term Treasuries have prospered due to the continued appetite for absolute yield from investors, particularly from foreign buyers and hedge funds. "The yield curve at the beginning of the year was also sufficiently upward sloping, so it rewarded investors for taking on longer maturities," she said. "The yield spread between the two-year and 30-year Treasuries has narrowed over 100 basis points since year-end 2004. At some point, the small incremental pickup in yield on longer Treasury securities should slacken investor demand."

The worst-performing portion of the bond markets has come from lower-quality credits, Roy noted. "Absolute lower rates and tight spreads have finally started to get investors a bit nervous about loading up on more risky assets." she said.

The Fed has raised short-term interest rates by 225 basis points over the past year to 3.25%. However, the 10-year Treasury yield recently hit 3.80%, a 15-month low; and bond yields, in general, have been steadily dropping for the past year. Roy is "surprised" that longer rates -- beyond 5 years -- have been declining.

"With GDP growth at 3.5% and reported inflation hovering around 2.5%, the fundamentals simply don't support a 4.00% ten-year yield," she said. "We expect the yield curve to start to become steeper at some point as longer rates move higher, and the Fed stops tightening." Standard & Poor's expects the Fed Funds rate to finish at 4.00% by the end of 2005, while Roy has a 3.75% target.

But the manager cautioned that, should inflation shows any signs of resurgence, long-term rates would also rise. "The absolute low levels of interest rates have made it increasingly difficult for investors to hit minimum yield targets," she said. "The upward sloping yield curve has enticed investors to pick up incremental returns by extending maturities, and this strategy has paid off in performance. Mr. Greenspan has apparently done a good job convincing investors that inflation is low and staying low and, therefore, they demand very little compensation or risk premium for buying longer securities."

Roy currently recommends bond investors should probably take a conservative stance and focus on shorter-duration instruments. "Aside from duration, there are some very attractive opportunities in more defensive securities such as floating-rate bonds that will benefit as rates rise," she stated.

Two of the biggest events in domestic bond markets this year -- Standard & Poor's historic downgrade of Ford Motor (F) and General Motors (G) bonds to "junk" status; and an announcement by the U.S. Government that it may resume issuance of 30-year bonds after a nearly four-year hiatus -- promise to increase volatility in bond markets going forward. Roy noted that these downgrades "served to underscore the fact that there is risk inherent in these types of securities."

However, Zane Brown, director of fixed income at Lord, Abbett & Co. noted that while the Ford and GM downgrades "have caused volatility among those and other auto-related credits, the junk bond market has absorbed this new supply pretty well." Brown indicated that when GM first issued its profit warnings, the entire bond universe -- both investment-grade and junk -- was immediately re-priced.

Looking at the remainder of the year, Brown believes more bond investors will probably move to higher-yield bonds to capture the additional yield returns that most investment-grade securities now lack. "The best returns will likely come from outside the investment-grade space," he said.

High-Quality Corporate Bond Funds

Best Performers Mid-Year 2005 Returns (%) Worst Performers Mid-Year 2005 Returns (%)
Vanguard Long Term Investment Grade Fund/Admr (VWETX)

+7.3

John Hancock Tr:Lifestyle Cnsrv 280/III

-3.7

Vanguard Long Term Bond Index (VBLTX)

+6.9

Potomac Evolution Managed Bond/Investor (PEMVX)

-2.6

Calvert Long-Term Income Fund A (CLDAX)

+6.5

PIF Preferred Securities/Adv Sel

-1.8

Delaware Group:Extended Duration Bond Fd/I (DEEIX)

+4.9

Forum Fds Investors Bond Fund (FOIBX)

-1.3

Lebenthal Funds Taxable Municipal Bond Fd (LTMBX)

+4.9

IMS Strategic Income Fund (IMSIX) -1.2

Government Bond Funds

Best Performers Mid-Year 2005 Returns (%) Worst Performers Mid-Year 2005 Returns (%)
American Century Target Maturity 2025/Inv (BTTRX)

+18.1

ProFunds: Rising Rates Opportunity/Sv (RRPSX)

-12.9

ProFunds:US Government Plus/Iv (GVPIX)

+14.1

Rydex Srs Tr:Juno Fund/C (RYJCX)

-10.1

Wasatch-Hoisington:US Treasury Fund (WHOSX)

+13.5

Potomac Contrabond Fund/Investor (PCBDX)

-5.7

Rydex Srs Tr:US Government Bond Fund/Inv (RYGBX)

+13.3

Thrivent US Govt Zero Coupon Target Fund

-0.3

American Century Target Maturity 2020/Inv (BTTTX)

+12.9

Reynolds Balanced Fund (RUSGX)

-0.1

SOURCE: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends. Preliminary data as of 6/30/05.

Contact Bob Keane with questions or comments at: .

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