Bond Funds May See Meager Results

NEW YORK (TheStreet) -- Worried about budget uncertainties in Washington and debt problems in Europe, investors have been seeking safety in bond funds. During the first six months of this year, inflows into taxable bond funds totaled $92 billion, according to Morningstar. Should you join the crowd that is rushing into bonds? Probably not. Chances are that bond funds will deliver puny returns in coming years.

To size up the outlook for bonds, consider a forecasting method long promoted by John Bogle, founder of Vanguard Group. According to Bogle, total returns in the coming decade should about equal the current bond yield. He says that the system works because most of bond returns come from the yield. If Bogle is right, the annual return of bonds will be about 2.9%, which is the current yield on 10-year Treasuries.

Although Bogle's system may seem simple, it has proved remarkably accurate in the past. In January 2000, Treasuries yielded 6.5%. During the next 10 years intermediate government bonds returned 6.2% annually, according to Ibbotson Associates. The system even worked during the 1970s, a time of roaring inflation and rising interest rates. At the beginning of the decade, Treasuries yielded 7.8%, and intermediate government securities returned 7% during the coming 10 years.

Some investors worry that bonds could do even worse than Bogle's system suggests. Recalling the years of high inflation, the bears worry that bond funds could lose money. When rates rise, bond prices fall. And many economists figure that interest rates will rise as the economy recovers. Could bond funds finish in the red for years to come?

Probably not. Since 1926, there have only been nine years when intermediate government bonds lost money, according to Ibbotson Associates. Bonds have never suffered more than two losing years in a row.

The worst year came in 1994 when intermediate governments lost 5.1%. Worried that the economy was overheating, the Federal Reserve raised short-term rates from 3% to 5.5% in a matter of months. Caught off guard, investors responded by dumping bonds.

Since then, the Federal Reserve has moved cautiously, signaling moves in advance to avoid surprises. From 2003 to 2006, the Fed raised rates from 1% to 5.25%. During that period, the markets adjusted smoothly. Most bond funds sailed along without recording any losing years.

Compensating for Low Yield

Whether or not the Federal Reserve raises rates, investors who buy and hold plain-vanilla bond funds are likely to record meager returns in coming years. To get better results in today's low-yield environment, investors must take a more flexible approach, argues Margaret Patel, portfolio manager of Wells Fargo Advantage Diversified Income Builder ( EKSAX). Patel roams through the bond universe, emphasizing investment-grade issues one year and high-yield bonds the next. When bonds look rich, she can put up to 30% of assets in dividend-paying stocks. Recently Patel's approach has been working. During the past three years, the fund has returned 6.9% annually, outdoing 77% of peers in the conservative allocation category.

These days Patel is steering away from investment-grade bonds because the yields are small. She says that yields are only 2.5% to 4.5% on typical investment-grade corporate bonds with maturities of seven to 10 years. To find more appealing yields, she has put 24% of the portfolio into stocks.

It is possible to find situations where a company's common stock yields about the same as the bonds. That is very different from the recent past when bonds typically yielded more than stocks. Besides paying relatively rich yields, stocks also offer the chance to obtain capital appreciation and rising dividends. Stock yields are relatively rich because the shares are undervalued, says Patel. "Investors are still fearful that markets will collapse again and stocks will drop 20%," she says.

A stock holding of the fund is Emerson Electric ( EMR), which makes motors and industrial automation systems. The stock yields 2.5%, and the company should report solid earnings gains as global demand for capital goods increases, Patel says.

To get extra yield, she has most of the portfolio in high-yield bonds, which are rated below investment grade. Those yield from 5.5% to 8%. High-yield bonds come with risk, but Patel says that the annual default rate is only 3%. The higher yields of the bonds compensate for the risk of default, Patel says, and she expects that default rates will drop in the next year to 2% as the economy grows and companies refinance their debt.

As investors worry less about defaults, high-yield prices could rise slightly, says Patel. But investors are not likely to achieve significant capital gains from bond portfolios in coming years, she says. Most returns will come from yields. If that is the case, shareholders in Patel's fund could see decent results. The fund currently yields 5.3%.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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