Finding buoyancy in bonds

As Holmes might have said to Dr. Watson: "It's elementary, dear friend, all in the math." With interest rates low over the past few years and the stock market in constant turmoil, savvy investors have flocked to bonds and bond mutual funds.

Assets in bond funds now total more than $1 trillion. No surprise. Returns for bond funds have typically outpaced stock funds over the past year, although more than three times as much money can be found in the stock funds.

As for the rest of this year, some bond-fund managers express mild optimism.

"We've had a substantial flow of assets into our bond funds, yet we expect that to continue," says Jim Cusser, senior vice president and portfolio manager with Waddell & Reed, a mutual-fund group in Overland Park, Kan.

Mr. Cusser manages two bond funds: the Waddell & Reed Advisors Bond Fund, an all-purpose fund that includes mortgage products, corporate issues, and junk bonds, and the Waddell & Reed Government Securities Fund, which includes mortgage-backed securities as well as US Treasury issues. The two funds hold more than $1.2 billion in assets.

Like many bond-fund managers, Mr. Cusser believes that interest rates will start to inch back up, especially for long-term bonds. The impetus, he says, will come from higher inflationary expectations, including a rising federal deficit.

Yields on long bonds are currently about 5.75 percent; Cusser believes they will hit 6.25 percent by the end of the year. Short- to intermediate-term bonds with durations of two years or less should either rise more slowly or stay the same, he says. Two-year issues currently yield about 3.35 percent.

So far this year, the major bond indexes tracked by information firm Lipper Inc., in New York, are up.

Short-term, investment-grade bonds are up just under 1 percent; intermediate bonds are up more than 1 percent; US government issues are up more than 1 percent; GNMA (mortgage products), are up more than 2.5 percent, and quality corporate bonds are up about 1 percent.

Only a few stock-fund categories – small-cap funds, mid-cap value funds and international funds – are in the black.

Watching interest rates

Apparently "slow but steady" is the slogan on fixed-income products so far this year, and bond traders are watching interest rates carefully. Over time, higher rates work against bonds, since the price of bonds drops as rates rise.

"Interest rates look like they are poised to go higher, but not just yet," says Scott Berry, who tracks bond funds for Morningstar Inc. "Bond funds should continue to deliver."

If rates do rise, many bond-fund managers attempt to minimize losses by buying short- and intermediate-term bonds.

Bond experts generally agree that investors looking to start, or add to, their bond-fund portfolios should consider high-yield (junk), corporate, and short-to-intermediate term municipal bond funds.

"As the US economy continues to improve, high-yield bonds should be less vulnerable to default risk as the income flows of their companies improve," says Mr. Berry. "Carefully selected corporate bonds should also benefit from better economic conditions."

Municipal bonds, of course, are unique products issued by state and local governments. Cusser believes that for the past year or so "municipal bonds have been on sale," since yields are roughly equal to yields on US Treasury issues.

Like Treasuries, municipal bonds also provide especially desirable tax breaks to investors in high tax brackets.

A bond-buyer's check list

When buying a bond fund, analysts say investors should consider a number of factors:

• Yield – the interest distributed to fund shareholders.

• Total return – Yield plus the price appreciation of the shares in the fund.

• Expense ratio – the percentage of assets used for administrative and management costs. For bonds, the ratio should be well under 1 percent.

• Consistency – Look for a pattern of productive performance over time by the fund manager.

Generally, bond funds have large portfolios, carrying substantial numbers of individual bond instruments. Mr. Cusser, for example, tends to have about 100 different bond instruments in his Advisors Bond Fund. Just about everyone "should have a balanced and diversified portfolio," which means exposure to a bond fund, says Cusser.

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