On the flip side, losses in corporate junk bonds and other lower-quality issues demonstrated why risk is a four-letter word.
The question now for income-oriented investors is whether there still are good reasons to be afraid for markets and the economy, or better reasons to think the worst has passed.
Rising mortgage defaults helped trigger a severe global money crunch in July and August. as many banks and investors pulled back from extending credit. One result was a dramatic “flight to quality,” with many investors rushing into U.S. Treasury securities and government bonds of other major countries as a haven.
As buyers bid up prices of those bonds, the yields on the securities tumbled. The 10-year Treasury note yield slumped from 5.03 percent on June 30 to 4.59 percent on Sept. 28, and in mid-September fell as low as 4.32 percent.
The rally produced a total return, price change plus interest income, of 5.3 percent for long-term government bond mutual funds in the quarter, on average, according to Morningstar Inc. That was more than five times the gain of the average U.S. stock fund in the period.
Funds that own other types of high-quality bonds also generated positive returns of between 1 percent and 4.5 percent in the quarter, thanks in part to expectations that the Federal Reserve would begin to cut short-term interest rates to ease the credit crunch.
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And the Fed didn’t disappoint: On Sept. 18 it cut its key rate to 4.75 percent from 5.25 percent.
Since then, however, the credit crunch has continued to abate, and data on the domestic economy have suggested that the pace of growth is slowing but isn’t collapsing.
That leaves bond investors wondering what the Fed will do next. If its policymakers continue to cut short-term rates, yields on longer-term bonds also might decline. At the same time, more Fed cuts would drag down yields on money market funds and bank savings certificates, which could drive investors in those accounts to try to lock in longer-term yields.
Many analysts are sticking with the view that the Fed is more likely to cut rates in the months ahead than hold steady or raise them.
“The economy is slowing down, but it’s a gradual process,” said Ethan Harris, economist at Lehman Bros. in New York. He expects the Fed’s key rate to be at 4 percent by mid-2008.
Shorter-term Treasury yields also suggest that investors are betting on more rate cuts. The two-year T-note yield rose Friday, but at 4.09 percent it was nearly 0.70 of a point below the Fed’s rate. The 10-year T-note yield, at 4.64 percent Friday, also was below the Fed’s rate.
If nothing else, the rush of money into government bonds in July and August showed how they can play the role of a bulwark in a portfolio, rising in value during a market panic and at least partly offsetting losses on stocks and other higher-risk assets.
If the global credit crunch worsens again, or economic data turn grim, high-quality bonds would be the most likely beneficiaries.
As for higher-risk bonds, such as junk issues, they have been recovering since mid-August as credit-crunch worries have dimmed. But the average junk-bond fund remained in the red in the quarter, producing a 0.02 percent negative total return, according to Morningstar.
Hit even harder in the quarter: bank-loan funds, which invest in syndicated bank loans often used to help finance corporate buyouts. The average bank-loan fund sank 1.6 percent in the quarter.
The junk-bond and bank-loan sectors could rally this quarter if the economy stays reasonably healthy, some analysts say. But many also warn that the number of companies defaulting on their debts is expected to rise.