Jan. 3, 2005 — While many observers predicted a poor year for fixed-income instruments in 2004, high-quality bond funds delivered respectable gains, going against the tide of rising short-term interest rates and relatively strong equity markets. The average high-quality taxable bond fund returned 3.1%, not much worse than the 4.5% gain they recorded last year.

The top performing high-quality corporate portfolio with a 12.2% gain, the Loomis Sayles Fixed Income Fund (LSFIX), was also the champion in 2003, when it surged 30.2%. The $374-million portfolio is managed solely by Daniel Fuss.

Milton Ezrati, senior market strategist at Lord Abbett, was not surprised by how bonds have performed.” We were skeptical of forecasts earlier this year which claimed bonds would fall into negative territory,” he said. “At the start of 2004, the yield curve was incredibly steep, almost at record levels. This told us that the bond market already anticipated the rise in short-term interest rates. And, in fact, the subsequent hike in rates was less dramatic than what the bond markets had built in — so we predicted a rally, even though short-term rates rose.”

Steven Kaseta, who co-manages the Loomis Sayles Investment Grade Fixed Income Fund (LSIGX) and the Loomis Sayles Investment Grade Bond Fund/Y (LSIIX), two of the year’s top-performing high-quality bond portfolios, attributes the bond markets’ decent returns to one primary factor: “There was a gradually and steadily improving domestic economy, which boosted the credit quality of corporate America, allowing them to de-lever their balance sheets via increasing free cash flows and debt reduction,” he said.

To be sure, investors became extremely wary of putting their money into bonds. Through the end of November 2004, taxable bond funds received only $1.4 billion in net new cash, compared with $40.0 billion for the same period in 2003.

Kaseta noted that 2004 presented an “anomaly” for the bond market. “While the Federal Reserve has shifted to a more restrictive monetary policy, longer-term interest rates beyond the intermediate sector — say, beyond the 7-year maturity of the yield curve — have actually declined this year,” he said. Kaseta explained that typically, a tighter monetary policy results in an increase in interest rates across the yield curve.

“This unusual dynamic appears to be the result of the continued drop in the value of the U.S. dollar in relation to other global currencies, particularly the yen and the euro, among others,” Kaseta added. “The decline in the dollar has been met by increased foreign central bank buying of our currency as other nations, particularly Japan, attempt to limit the degree to which the dollar falls. These central banks are simultaneously attempting to limit the appreciation of their local currencies in relation to the dollar to help defend their exports on world markets.”

Kaseta noted that within the high-quality bond universe, corporates have generally outperformed Treasuries and government bonds on a duration-neutral basis. “Investors’ expectations for credit quality is improving, because the economy is getting better,” he said. “Corporate bond yield spreads have narrowed, indicating the willingness of investors to increasingly buy corporates. Corporate bonds provide a nice yield advantage over Treasuries, and remain attractive investments, though this advantage diminished a bit this year.”

Kaseta has an optimistic outlook for high-quality bonds for 2005. “The Fed Funds Rate now stands at 2.25% and we expect it to reach 3.25% by the end of 2005,” he said. “Despite the expectation that rates will rise in the next year, corporate bonds are likely to remain an attractive investment since market fundamentals, particularly the anticipated corporate cash flows, should continue to be favorable.”

With this relatively constructive outlook, Kaseta recommends that investors “maintain exposure to the corporate bond market, particularly since the prospects for further gains in the equity market in 2005 are uncertain.”

Ezrati adopts a more cautious stance on bonds.

“We think all the gains have been made in the fixed income market,” he said. “I think that high-quality bonds will suffer small capital losses this year to adjust to the rising interest rate environment.”

Ezrati recommends that investors bring their exposure to Treasuries and high-grade bonds down, and move assets more into U.S. stocks and equity-like products in the fixed income market, like convertibles or high-yield bonds.

Standard & Poor’s Investment Policy Committee currently has a recommended asset allocation of 45% in U.S. equities, 15% in foreign equities, 25% in bonds, and 15% in cash.

High-Quality Corporate Bond Funds

Best Performers 2004 Returns (%) Worst Performers 2004 Returns (%)
Loomis Sayles Fixed Income (LSFIX) +12.2 Loomis Sayles Benchmark Core Bond/I (LSCFX) -3.1
Loomis Sayles Investment Grade Fixed Income (LSIGX) +10.3 STAAR Investment Trust Short Term Bond -1.6
Delaware Group:Extended Duration Bond Fd/I (DEEIX) +10.1 Optimum Q Capital Conservation (OQCCX) -1.5
Loomis Sayles Investment Grade Bond/Y (LSIIX) +9.9 LEADER Funds:Intermediate Bond Fund/Inv A (MIBIX) -0.6
Vanguard Long Term Corp/Admrl (VWETX) +8.5 Van Kampen Limited Duration/C (ACFWX) -0.6
Best Performers Fourth Quarter 2004 Returns (%) Worst Performers Fourth Quarter 2004 Returns (%)
Loomis Sayles Fixed Income (LSFIX) +6.3 Loomis Sayles Benchmark Core Bond/I (LSCFX) –6.2
Loomis Sayles Investment Grade Bond/Y (LSIIX) +4.9 Strategic Partners Total Return Bond/C (PTRCX) -3.3
Loomis Sayles Investment Grade Fixed Income (LSIGX) +4.6 Janus Aspen Srs:Flexible Income/Svc -2.8
Manufacturers Inv Tr:Lifestyle Cnsrv 280/III +4.5 Target Portfolio Trust:Total Return Bond (TATBX) -1.7
Delaware Group:Extended Duration Bond Fd/A (DEEAX) +3.6 STAAR Investment Trust Short Term Bond -1.5

Government Bond Funds

Best Performers 2004 Returns (%) Worst Performers 2004 Returns (%)
American Century Target Maturity 2030/Inv (ACTAX) +16.9 ProFunds:Rising Rates Opportunity/Sv (RRPSX) -11.7
PIMCO Funds:Real Return Asset/Ist (PRAIX) +13.3 Rydex Srs Tr:Juno Fund/C (RYJCX) -9.7
American Century Target Maturity 2025/Inv (BTTRX) +12.3 Regions Morgan Keegan Select Ltd Maturity/C (RMKLX) -1.4
American Century Target Maturity 2020/Inv (BTTTX) +12.0 North Track Funds Government Port/C (GVTCX) -0.7
Wasatch-Hoisington:US Treasury Fund (WHOSX) +10.2 Pacific Capital Ultra Short Term Govt/B (PCUBX) -0.6
Best Performers Fourth Quarter 2004 Returns (%) Worst Performers Fourth Quarter 2004 Returns (%)
Thrivent US Govt Zero Coupon Target Fund +5.5 ProFunds:Rising Rates Opportunity/Sv (RRPSX) -2.8
American Century Target Maturity 2030/Inv (ACTAX) +4.5 Fairport Government Securities Fund (ROGVX) -2.3
PIMCO Funds:Real Return Asset/Ist (PRAIX) +4.4 Rydex Srs Tr:Juno Fund/C (RYJCX) -2.1
Manufacturers Inv Tr:Real Return Bond/III +2.8 Flex-fund:US Government Bond Fund (FLXBX) -0.5
TA IDEX PIMCO Real Return Tips/B (IRRBX) +2.6 Regions Morgan Keegan Select Ltd Maturity/C (RMKLX) -0.5

Source: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Preliminary data as of 12/31/04.

Contact Bob Keane with questions or comments at:bkeane@investmentadvisor.com.