High-Quality Bond Funds -- Third Quarter 2002 Revi

Oct. 2, 2002 — Stock market weakness, concerns about the economy, and the threat of war and terrorism has resulted in historically low short-term interest rates and a flight to quality that has been favorable for the bond markets.

Not surprisingly, the returns from high-quality bond funds have stood out against steep losses that equity funds have suffered. The average total return for high-quality bond funds through the end the third quarter is 5.3%, compared to a loss of -27.3% for the average domestic equity fund.

Funds overweight in high-quality corporate bonds that have been taking advantage of the steepening yield curve — assuming more interest-rate risk as short-term rates have fallen and long-term rates have edged up — bested their peers through the end of the third quarter.

For Varun Mehta, manager of Mason Street Fds Select Bond Fund/A (MBDAX), an 11.1% return this year through the end of the quarter was primarily due to extensive and detailed internal credit analysis his team goes through to pick credits that have happened to outperform the corporate bond universe, he says.

The intermediate bond fund has steered clear of the telecom sector and “credits that have blown up”. The portfolio has been overweight in sectors such as building products, oil and gas, and consumer products. It has been underweight in sectors such as gas pipelines, cable, and broadcasting. In addition, Mehta says an overweight in TIPS (Inflation-Indexed Treasury bonds) and in mortgage securities helped to contribute to the fund’s strong performance.

Looking forward, the economic environment will continue to be weak for the rest of the year, according to many of the managers we surveyed, with strength starting to appear during 2003. Lower-quality corporate bonds should continue to be avoided, they say, and an overweight position in high-quality corporate bonds retained. Interest rates will stay low, with an increase not expected to take place until next year. Mortgage-related bonds should be underweighted due to higher prepayment risk and high volatility in the sector, they say.

High-Quality Bond Funds