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

Jan. 9, 2003 — The fixed-income market in 2002 was where nervous investors continued to take shelter from the falling stock market, a weak economy, and the fear of war and terrorism. Declining interest rates and rising demand helped drive bond fund returns over the past 12 months, giving fixed-income managers the upper hand for a third year.

High-quality corporate bond funds tracked by Standard & Poor’s returned a solid 7.1% for the year on average, versus a loss of 23% for the average U.S. stock fund. Out of the universe of 897 bond funds in the category, only 18 posted losses, which were mild compared to losses equity funds suffered over the period.

Taxable bond funds overall took in a record amount of cash as investors cotinued to seek refuge in 2002. Year to date as of the end of November, net inflows stood at a weighty $117.7 billion, versus a record $76.1 billion for all of 2001, according to the Investment Company Institute. Since credit risk was a main concern for the bond market in 2002, finding favorable issues, and avoiding credit blowups, was important to success.

For Kathleen Gaffney, co-manager of Loomis Sayles Bond/Instl (LSBDX), exposure to non-U.S. dollar denominated securities contributed postively to performance since developed markets, such as Canada, Norway, Sweden, New Zealand and Australia, had higher interest rates and more solid fundamentals. About a third of the fund’s portfolio is invested overseas. More defensive industries, such as health care and homebuilders, were winners for the portfolio. A top performer, the Loomis Sayles Bond fund returned 13.3% for the year.

The best-performing bond funds in 2002 were also positioned on the short end of the yield curve, with managers expecting that the Federal Reserve would continue to cut interest rates throughout the year. For Connie Plaehn, who heads up fixed-income investing at JPMorgan Fleming, duration strategy, as well as exposure to the mortgage sector, despite declining rates and prepayments, contributed positively to the performance of JPMorgan Bond/Instl (JMIBX). In corporates, the portfolio was overweight in the bank and finance. Her fund returned 11.9% in 2002.

From the managers that we spoke to, the outlook is for a slow economic recovery, with inflation remaining stable, or declining slightly, and interest rates gradually rising as the economy finds solid footing. With many professionals calling for caution next year, staying at the short end seems the safest advice right now. In corporates, Gaffney sees promise and value since yields are high relative to Treasuries, and because they have essentially underperformed over the last four to five years.

High-Quality Bond Funds Best Performers2002 Returns (%)Worst Performers2002 Returns (%)