Not a Spectacular Year for Bond Funds, but Consider the Alternative

Bond funds are for times like these.

The average stock mutual fund returned just 0.54% during the third quarter, and just 3.05% over the first nine months of the year, according to Lipper.

Bond funds, by contrast, are looking better and better: The average taxable bond fund returned 1.62% during the third quarter and 3.79% year to date. And those numbers are weighed down by the sorry performance of high-yield funds (which correlate closely with stocks), international funds (which correlate closely with foreign currencies) and global income funds (which also correlate with foreign currencies). Intermediate investment-grade bond funds -- the second most popular category after high-yield -- returned 2.71% during the third quarter and 5.88% over the first nine months.

The most popular kind of municipal bond fund did even better, taking into account that the dividend income is tax-exempt. National muni bond funds returned 2.28% during the third quarter and 6.34% year to date.

Not spectacular numbers, for sure. You get spectacular numbers from most kinds of bonds and bond funds only when interest rates are moving steadily lower. On the whole they've been more or less stable this year. But respectable numbers. Numbers that look awfully good when everything else in your portfolio is in the red.

Best and Worst Performing Bond Fund Categories, Third Quarter and Year-to-Date
Category	Q3 Total Return	Category	YTD Total Return
Emerging Market Debt	3.26%	Target Maturity	10.98%
U.S. Mortgage	2.92	Emerging Market Debt	10.08
General U.S. Treasury	2.79	General U.S. Treasury	9.10%
Global Income	-0.50	Global Income	0.17
High Yield	-0.87	High Yield	-2.55
International Income	-2.58	International Income	-3.13
Source: Lipper

Treasuries Lead the Way

Some of the best performance in the third quarter came from the Treasury market, where yields declined substantially as people came to the conclusion that the Fed's May 16 half-point increase in the fed funds rate was probably its last. From June 30 to Sept. 30, the 10-year Treasury note's yield went from 6% to 5.8%.

Treasury funds returned an average of 2.79% during the third quarter, and are up 9.10% year to date. Target-maturity funds, most of which invest primarily in Treasury zero-coupon bonds, or strips , gained 2.70% on average during the quarter, and 10.98% during the first three.

But while Treasury yields moved lower, causing the prices of the bonds to rise, most other U.S. bond yields stayed at relatively high levels. Most other U.S. bonds are issued by companies, and amid earnings warnings and sagging stock prices, bond investors were unwilling to lower interest rates for corporate borrowers. In many cases, they raised them. That caused underperformance by investment-grade corporate bonds, and severe underperformance by high-yield bonds.

Mortgage-Backed Boomlet

Mortgage-backed securities were an exception, outperforming their long-term average. U.S. mortgage funds, which returned an average of 5.81% over the past five years, gained 6.39% year to date and 2.92% in the third quarter.

Mortgage-backed securities compensate investors for the risk that mortgage rates will rise or fall dramatically, affecting the average speed at which homeowners prepay their mortgages. "Mortgages tend to do well in periods when interest-rate uncertainty wanes," as it did this year, says Roger Bayston, manager of (FSMIX Quote)Franklin Strategic Mortgage, a top-performing fund.

Meanwhile, various types of foreign bond funds delivered some of the best -- and some of the worst -- returns in bondland during the third quarter, on average anyway.

Emerging Markets Funds Surge

Emerging-markets bond funds were the best performers, returning 3.26%. Over the first three quarters they are up 10.08%.

A double-digit finish this year would be the second in a row for the volatile sector. Last year, the average emerging-markets bond fund returned 24.51% as emerging-market bonds returned from the depths to which investors had consigned them in the fall of 1998.

This year, emerging-market bond funds are excelling thanks mainly to the very high interest rates they pay, says Tom Cooper, a manager of (GMCDX Quote)GMO Emerging Country Debt, the largest and best-performing emerging-market bond fund in the third-quarter and for the year to date. Up 8.07% in the third quarter and 23.76% in the first nine months, it is also the best performing bond fund of any kind. (Unfortunately, the fund is out of reach to most investors. The minimum investment is $1 million.)

That is to say, emerging-markets bonds haven't experienced much price change this year, the way they did last year. "The key driver for performance this year has just been yield," Cooper says.

His fund outran the pack thanks in large part to its holdings of the bonds on which Russia defaulted in the fall of 1998, Cooper says. That debt was restructured over the summer, and the first interest payment in nearly two years was made on Sept. 30, he says.

Euro Sinks Foreign Funds

Meanwhile, other classes of foreign bond funds are among the worst performers so far this year. International income funds, which generally don't hold much U.S. debt, were down 2.58% in the third quarter and 3.13% for the year to date. Global income funds, which generally do hold U.S. debt in addition to foreign bonds, lost 0.50% in the third quarter and are up 0.17% for the year to date.

The determining factor for international funds, and the distinguishing factor between international and global funds, has been the weakness of euro, which is down nearly 15% against the dollar so far this year. The benchmark for international funds is 46% euro-denominated issues, while the benchmark for global funds is 32% euro-denominated. As the value of the euro falls against the dollar, the euro-denominated interest payments from those bonds convert into smaller dollar amounts. (Emerging-markets bonds, by contrast, are generally dollar-denominated.)

"Currency is the big item" in explaining the performance of international and global funds this year, says Lee Thomas, manager of Pimco's (PFORX Quote)Foreign Bond and (PIGLX Quote)Global Bond funds, both of which are near the top of the heap in their categories. "If you held any of these [euro-denominated issues] unhedged, your performance was down 2% to 3%" as a result of the currency depreciation alone.

The Pimco funds outperformed by unloading some British government bonds when they became extremely expensive, and adding some U.S. and German government bonds instead, Thomas says. The funds also benefited from owning Ginnie Mae mortgage-backed securities, and from positions in some of the most highly rated emerging-markets issues.

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