Notable Exceptions to a Bad Year for Bond Funds

Elizabeth Stanton

Last week, we examined the carnage in the bond market in 1999. Today, let's have a look at how bond mutual funds fared.

Certainly, it was the worst year in recent memory. But for most categories of bond funds, 1999 wasn't as bad as 1994. And some categories fared much better than others this year.

Risk Returned The best- and worst-performing bond mutual fund categories in 1999*
Category	1999 performance	Best/worst performance (year)
Emerging Markets	24.49%	51.11% (1993)
High-Yield	4.53	37.23 (1991)
Adjustable-Rate Mortgage	4.38	13.12 (1989)
Insured Muni	-4.69	-11.88 (1980)
General U.S. Treasury	-6.17	-6.17 (1999)
Target Maturity	-8.62	-12.93 (1987)
*Excluding money-market, ultra-short obligations, and single-state municipal funds. Source: Lipper.

Treasury funds took the brunt of it. As the Fed hiked interest rates, Treasury yields climbed steadily higher, doing the most damage price-wise to the longest-maturity issues.

Long-maturity Treasury funds had their worst year ever, losing an average 6.2%, according to Lipper. The only worse-performing fund category in 1999 was target maturity funds, most of which invest in Treasury strips, or zero-coupon bonds -- the most interest-rate-sensitive Treasuries of all. The worst-performing bond fund of 1999 was (BTTRX Quote)American Century Target Maturities Trust 2025, the longest-maturity fund in the group.

Fixed-Income Forum: Join the discussion on TSC message boards. For the same basic reason -- extreme sensitivity to rising interest rates -- long-maturity municipal bond funds also had a very bad year, losing an average of 4.6%.

Riskier bond funds fared much better than Treasuries and munis, as they typically do when rates are rising. The higher yields those bonds pay to compensate investors for taking on credit risk -- the risk that the issuer will default -- offset the impact of falling prices. Of course, it also helped that risky bonds got beat up so badly at the end of 1998 that they seemed to have nowhere to go but up. The two worst-performing categories in '98 were the two best in '99 -- emerging markets and high yield. Emerging-markets funds returned an average of 24.5% last year, high-yield 4.5%.

At the Top of the Heap

The best-performing bond fund of 1999 was, not surprisingly, an emerging-markets fund, (PHCHX Quote)Phoenix-Goodwin Emerging Markets Bond, with a 40.0% return on its A shares. Manager Peter Lannigan says he overweighted the countries that investors were most nervous about early in the year -- Russia, Brazil and Venezuela. Debt indices for those countries went up 165.7%, 40.7% and 29.9%, respectively.

Peter Lannigan
Source: Phoenix Investment Partners

"This market is characterized by a lot of fast money," Lannigan says. "There are a lot of hedge funds that invest in it without doing a lot of research. The advantage you can have if you're a fundamental investor, if you know and understand the economic and political complexion of a country, is that when prices sell off, rather than panicking you can correctly perceive buying opportunities."

The top-performing high-yield fund last year, Dreyfus Premier High-Yield Debt and Equity, owes its 32.8% return on its A shares to its roughly 25% allocation to stocks, co-manager John Koerber says. (Hey look, at least this high-yield fund's name tells you it buys stocks. Lots of them don't.)

John Koerber
Source: Dreyfus

High-yield funds have to have at least 65% of their assets in bonds, and Koerber kept to the minimum last year, investing 20% of the balance in stocks and 15% in convertible bonds (which count as half debt, half equity). Most of the stocks were high-yield debt-issuing companies, a sector that Koerber says is "underfollowed."

"If we like the bond, we may buy the equity," he says. "If they get discovered at all, they'll move." His best moves last year were investments in convertibles of EchoStar Communications (DISH Quote) and SBS Broadcasting (SBTV Quote), and the common shares of MGC Communications (MGCX Quote).

A Taxable Muni Fund Grabs the Spotlight

Perhaps the most surprising chart-topper was Heartland Taxable Short-Duration Municipal, the top-performing general bond fund. The category is more or less a catchall for funds that don't fit anywhere else. The category returned an average of 0.7% last year, and the Heartland fund returned 5.5%.

Tom Conlin
Source: Heartland Advisors

Taxable muni funds are rare because taxable muni bonds are rare, but Heartland's co-managers, Tom Conlin and Greg Winston, say that's a benefit to investors who aren't taxed at a high enough rate to benefit from tax-exempt munis. Because there are so few taxable muni issues, managers of corporate and other taxable bond funds generally ignore the entire sector. That means lower prices and higher yields for those willing to buy taxable munis.

Conlin and Winston are game because taxable munis are typically issued in conjunction with tax-exempt munis, and the managers also run two tax-exempt muni funds. "We can kill three birds with one stone," Conlin says. (An issuer may issue taxable debt because of a federal limitation on the amount of tax-exempt debt it can issue.)

Greg Winston
Source: Heartland Advisors

At the same time, taxable muni debt performs well in a bear market because most of it is short-maturity, which gives it relatively little interest-rate sensitivity. Issuers want their taxable debt to mature quickly because it is their most expensive debt.

A Hideous Year for a Trio of Muni Funds

Meanwhile, a few tax-exempt muni bond funds had a truly hideous year -- far in excess of the norm for a bear market. Three funds whose management was taken over by Cornerstone Equity Advisors in September 1998 after a long history of calamitous performance -- (CNCAX Quote)Cornerstone California, (CNNYX Quote)Cornerstone New York and Cornerstone High Yield -- haven't turned around yet, to say the least.

By dint of a lethal combination of extreme interest-rate sensitivity, serious credit problems and sky-high expenses, the California fund lost an astonishing 29.4%, the New York fund 18.22%, and the high-yield 12.27%.

Manager Lucia Tribuzio says the California and New York funds started the year with about twice as much interest-rate sensitivity as their benchmark indices. The California fund, in particular, had extremely heavy exposure to a variety of derivative called inverse floaters, its filings show.

An inverse floater pays a variable interest rate that moves in the opposite direction as a market interest rate. It works this way: A fixed-interest payment is divided in two parts, each sold separately: a conventional floater (variable-rate bond), and an inverse floater. The floater's interest rate rises and falls with market rates, and the holder of the inverse floater gets whatever's left over. If rates go up, the holder of the floater wins; if they fall, the inverse investor makes out.

On the credit front, the $63 million New York fund is virtually the sole owner of three bonds for various industrial development and urban renewal projects in Niagara Falls, all of which are in default. And the $10.6 million California fund at midyear held $1.8 million of Los Angeles Housing Authority bonds on the verge of default.

Finally, at midyear, each fund had an expense ratio greater than 4%, which is virtually unheard of. Tribuzio says the company is taking steps to replace its current service providers (such as accountants and custodians) with lower-cost alternatives.

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