Bonds may be better play for next year


The prospect of a slowing economy and of lower corporate earnings suggests that bonds may be a better place to be over the next 12 months than stocks.

Earlier this month, David Blitzer, chief economist at Standard & Poor's, bumped up the bond portion of his model portfolio to 30 percent from 20 percent and cut his cash position to 10 percent from 20 percent.

"The Federal Reserve will ease once the budget battle is resolved, and rates will drift down," Mr. Blitzer said. As a result, he figures 10-year bonds could provide total returns of 6 percent to 10 percent next year. That "pushes you close to an area where bonds look attractive compared to stocks," he said.

Investors who decide to allocate more money to bonds in the form of mutual funds, rather than individual securities, would do well to examine the records of the various fund groups.

Morningstar Inc., the fund rating company in Chicago, agreed to analyze the fixed-income funds offered by the biggest diversified mutual fund companies in the United States to see which had the highest returns.

A fund company had to offer at least three taxable and three tax-exempt mutual funds with 10-year records to get into the survey. Eleven families offering 700 bond funds made the cut.

Morningstar then calculated the 10-year, five-year, and three-year returns for each bond fund. To arrive at weighted returns for each fund group, 10-year returns were weighted 50 percent, five-year returns 30 percent and three-year returns 20 percent. Along with weighted returns, Morningstar calculated an overall risk score, based on three-year risk levels for all the bond funds.

The results, which showed a number of fund groups clustered around the average, support the long-held view that low expenses lead to exceptional returns in the fixed-income category.

The bond fund leader proved to be the Vanguard Group. Vanguard's bond shareholders received average annual returns that were nearly a full percentage point better than those of the average bond investor over the last 10 years. Vanguard's weighted returns were 9.52 percent, compared with an average of 8.54 percent for all bond funds. Moreover, Vanguard's managers did it with less risk than average.

At the other end of the spectrum was Prudential Mutual Funds, whose returns were the lowest in the survey. The Prudential funds had a weighted return of 7.35 percent a year, or 2.17 percentage points a year less than at Vanguard.

The difference may not seem like much, but someone who invested $10,000 in Prudential funds in the combination described would have reaped $4,503 less over the last 10 years than investors with $10,000 in Vanguard.

For all three fund groups at the bottom, the big difference is commissions. While the seven firms in the middle managed to provide weighted returns within 40 basis points, or hundredths of a percentage point, of the average bond fund, Merrill Lynch, Smith Barney and Prudential fell at least 60 basis points below average.

What ties these brokerage firms together is their widespread use of multiple classes of shares, often carrying a 12b-1 fee, which can run to 0.75 of a percentage point. These fees, which cover brokers' commissions but are taken out of investors' annual returns, are a major drag on performance.

Another solid performer was the Putnam group of funds, long known for its fixed-income capabilities. Putnam has scored big in recent years with its corporate bond and tax-free portfolios. Among Putnam's top performers: Putnam Convertible Income Growth, Putnam High Yield, Putnam Income and Putnam Tax-Free High Yield.

Like Vanguard, Fidelity's standouts span the fixed-income spectrum, from the high-yield Fidelity Capital and Income to Fidelity Investment Grade Bond and Fidelity Government Securities. On the tax-exempt side, Fidelity Aggressive Tax-Free and Fidelity Municipal Bond are stars.

Good performance and sky-high risk are the trademarks of Twentieth Century, in both the bond and the stock fund categories. Its risk score, the highest among the 11 fund groups, can be attributed primarily to the Benham Target Maturities portfolios, acquired in June with the Benham funds.

Benham Target Maturities 2020, for example, which invests in zero-coupon bonds that mature in that year, carries considerable interest-rate risk. The fund's risk score is four times higher than the average bond fund. This year, the 2020 fund is up 48 percent. Last year, it handed investors an 18 percent loss.

Even when the target funds are eliminated from the study, Twentieth Century still ends up with a risk rating above average. Its Long-Term Bond fund has fallen 35 percent more than the average taxable bond fund in down periods, while Benham European Government Bond fund has fallen 31 percent more.

Although Prudential failed to shine in performance, its investors probably sleep well at night. Prudential's funds came in with very low risk ratings, especially on the taxable side. The other fund company with an exceptionally low risk rating was Baltimore's T. Rowe Price. On average, its government and corporate bond funds lost 20 percent less than all taxable bond funds in down periods.

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