BOSTON — Many bond mutual funds emerged from the third quarter looking like the East Coast's drought-ravaged lawns - shriveled and brown.
Rising interest rates stunted the performance of US bond funds. Only foreign bond funds gained significantly, thanks to the decline of the dollar against the euro and, especially, the yen.
The fourth-quarter outlook is uncertain as bonds continue to confront challenges ranging from the inflation jitters of US central bankers to the growing appeal of foreign securities, say bond analysts and fund managers.
"The bond market is at a very difficult time," says Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc. in Chicago. "The only thing we have to fear is the Fed itself."
Bonds suffered especially because of fears the Federal Reserve will tighten interest rates in addition to the two, quarter-point hikes already this year.
Last week, Fed officials decided to leave rates alone, but indicated they were leaning toward future rate hikes. "The Fed will probably lift us another quarter point," before the end of the year. says Joseph Portera, manager of the Mainstay International Bond A fund in New York.
Bonds will also continue to suffer because of fear that computer software in much of the world will seize up on Jan. 1 because it is not programmed to properly read year 2000.
Concerned that Y2K computer glitches might debilitate credit markets, US corporations issued an unusually high level of debt in recent months. The high supply lifted bond yields, hurting bond prices and investors, say market analysts. "We think there will be minor [computer and market] disruptions but no major problems," says George Simon, debt strategist at A.G. Edwards in St. Louis.
Bonds could also stumble if the dollar continues its slide against the yen and euro, in part because of an apparent rebound in East Asia, Europe, and other corners of the world economy. Some investors fear the Fed might raise interest rates in part to shore up the dollar.
Already, a rising trade deficit and the comparatively high price of US equities and other assets is apparently straining the supply of foreign credit for investment in the United States.
After peaking in 1996 at 5.4 percent of gross domestic product (GDP), foreign net lending to the United States has steadily fallen to 1.5 percent of GDP, according to figures for the first half of the year. The net inflow of foreign credit averaged 4.3 percent of GDP from 1995 until 1997, according to Moody's in New York.
"No comparably measured stretch of recent US economic history comes close to matching so great a net supply of credit from abroad," according to John Lonski, senior economist for Moody's.
The apparent imbalance makes the bond market of October 1999 resemble that of October 1987, the month of the "mini-crash" on Wall Street. Shrinking foreign credit, a record trade deficit, and a strengthening world economy all recall that brief but brutal bear-market mauling, according to Mr. Lonski.
But if history is a guide, a correction in securities markets - especially in stocks - could signal a brief buying opportunity in bonds as investors seek the safety of the fixed-income market. Four times during the past 12 years, the bond market has gained from a rout in equities, according to Salomon Smith Barney Inc. in New York.
Today, municipal bonds and corporate bonds - and the mutual funds that hold them - offer the best investor values among bonds. "Municipal bonds are very attractive compared to Treasuries," says Mr. Simon.
Also, because of the surge in debt issuance by companies worried about a computer failure on Jan. 1, Mr. Wesbury says "there's fantastic value in corporate bonds today."
Most bonds funds have struggled to stay in the black in 1999. As of last week, the average return of the 3,468 bond funds tracked by Chicago-based Morningstar was minus 1.7 percent. Several foreign-bond funds produced double-digit returns during this period. High-yield bond funds are also doing well for the year, despite a minus 2.1 percent average drop-off in the third quarter.
Fund name YTD 3-yr.*
Phoenix-Goodwin Emerg Mkts Bd A 20.4% 1.0%
Fidelity New Markets Income 18.2 4.5
Fidelity Advisor Emerg Mkts Inc T 18.1 4.2
Dreyfus High-Yield Securities 16.1 6.5
Third Avemue High-Yield 15.0 N/A
Summit Emerging Markets Bond 14.9 N/A
Rydex Juno 14.3 0.6
Source: Morningstar Inc. as of 10/4
*Annualized N/A - not available
(c) Copyright 1999. The Christian Science Publishing Society