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High-Quality Bond Funds -- First Quarter 2004 Review

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April 1, 2004 — Reports of the demise of the bull run for bonds may have been somewhat premature.

High-quality bond funds almost uniformly posted modest gains during the first quarter of 2004. Fixed-income securities received an unexpected boost from increased geopolitical tensions and a lackluster jobs report in the U.S., bringing into question the strength of the global economic recovery.

“Given the weak jobs numbers, the terrorist attacks in Madrid, and the continuing turmoil in the Middle East, some investors felt it made sense to move money into the safe haven of bonds, particularly the higher-quality securities,” said Zane Brown, Director of Fixed-Income Management at Lord Abbett.

“Solid economic growth, continued corporate fundamental improvement and declining interest rates have driven these relatively good returns,” said Chris Molumphy, Chief Investment Officer of Franklin Templeton’s Fixed-Income Group. “At the company level, we’ve seen profits continue to grow, and cash build on balance sheets. The ratio of debt to operating cash flow has declined from peak levels in the third quarter of 2002; and balance sheet liquidity is at a 39-year high. As debt holders, these are all very positive and contribute to current valuations.”

Molumphy noted bonds with longer maturities have outperformed their short-term counterparts, due to the environment of declining interest rates. “Longer-duration securities, which are more interest rate-sensitive, will typically outperform shorter-duration investments in this environment,” he said.

Jeffrey Gundlach, co-manager of the TCW Galileo Total Return Bond Fund/I (TGLMX), explained, “since interest rates fell in the first quarter, longer-duration bonds had the greatest price gains. Also, longer-duration bonds have higher yields in the current steep yield curve environment.”

What the Federal Reserve does with interest rates will be a key factor in the near-term performance of bonds.

“The Fed will probably not raise rates until after the Presidential election, unless we see very strong jobs numbers, perhaps in the summer,” Brown noted. “But if rates remain low, this bodes well for bonds. What the Fed does will influence the performance of bonds with one-to-five year maturities; inflation will determine what happens to bonds with maturities five-years and longer. Both the Fed and inflation look benign right now, as such, it should be a pretty respectable year for bonds.”

Looking ahead, Molumphy believes high-quality corporate bonds will likely perform well, but not at the levels of 2003. “Spreads have tightened a great deal since October 2002, but we have a long way to go before reaching the tightest spreads of the last decade,” he noted.

Gundlach sounds a somewhat more cautionary note: “High-quality corporate bonds will likely have a decent year, but most of their outperformance has already occurred early on,” he said. “From here on, given the tightness of spreads, investors should favor Treasuries on a risk-adjusted basis. But corporates will probably perform reasonably well on an absolute basis.”

High-Quality Bond Funds

Best Performers First Quarter 2004 Returns (%) Worst

Performers First Quarter 2004 Returns (%)

PIMCO Funds:All Asset Fund/Instl (PAAIX) +5.9%

Dreyfus Instl Yield Advantage Fund/Instl (DIYAX) -0.7%

Delaware Group:Extended Duration Bond Fund/I (DEEIX) +5.2%

Dreyfus Premier Yield Advantage/D (DYADX) -0.2%

Vanguard Long Term Bond Index (VBLTX) +4.6%

FFTW Funds US Short-Term Portfolio (FFSTX) -0.1%

PIMCO Funds:Real Return II/Ist (PIRRX) +4.6%

Dreyfus Premier Short Term Income/B (DSHBX) 0.0%

Consulting Group Capital Markets:Long Term Bond (TTRUX) +4.5%

SmithGraham Instl SG Yield Plus 0.0%

Source: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Data as of 3/31/04.