Bond investors, like stock investors, regained some confidence in April and May — only to start losing it again in June.
The result was a bifurcated quarter for bond mutual funds that made for a mixed performance among fund categories.
Portfolios of high-quality bonds generally racked up negative returns in the three months, as some investors pared their holdings, while funds that own higher-risk bonds, such as junk issues, scored gains as buyers returned.
In June, however, those trends reversed as concerns about the economy and the financial system resurged.
There’s another worry that may trump all others for buy-and-hold bond investors: the continuing climb in prices of commodities, including oil. That has stoked inflation, which is the biggest long-term threat to bonds because it erodes fixed-rate returns.
The trend in the market yield on the 10-year U.S. Treasury note, a benchmark for other long-term interest rates, shows the mood shifts that have rocked the bond market this year.
The T-note yield began the year at 4.03 percent, then sank as Wall Street’s credit crunch worsened and investors looked for a haven. By mid-March — just after brokerage Bear Stearns Cos. collapsed — the yield fell as low as 3.3 percent, as investors, fearing the financial system could unravel, rushed into the safety of Treasuries.
But confidence revived in April and May after the Federal Reserve began lending huge sums to struggling banks and brokerages. Some investors began to sell low-yielding Treasuries in favor of riskier bonds, including junk issues. By late May, the T-note yield was at 4.08 percent.
It has since pulled back, ending last week at 3.98 percent, amid revived fears of a severe U.S. recession that would pose new threats to the financial system.
“The consumer is in real trouble in a lot of different ways,” said Jim Kauffmann, a bond fund manager at ING Investments in Atlanta. He notes that many Americans find their personal finances squeezed by falling home prices and banks’ unwillingness to lend, at a time when the economy is shedding jobs.
The risk of a serious recession is causing some investors to again shun high-yield junk bonds: debt of companies that are rated below investment-grade.
The average yield on an index of 100 junk issues tracked by KDP Investment Advisors fell as low as 9 percent early in May. By the end of the quarter, the yield had rebounded to 10.24 percent, as investors again pulled back from the bonds. (Yields rise as bonds’ prices decline.)
Despite double-digit yields on many individual junk issues, Martin Fridson, head of bond research firm Fridson Investment Advisors in New York, believes it’s too early for investors to jump with both feet into the junk market.
If the economy worsens, more companies are likely to find they can’t pay their debts, leading to more bond defaults, he said.
In the 12 months through May, 1.45 percent of junk bond issues worldwide defaulted — a 31-month high, according to Standard & Poor’s. But S&P expects the default rate to surge to 4.7 percent in the next 12 months.
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“The default rate still has a long way to go,” Fridson said.
For junk-bond mutual fund investors, that could mean continued rough sledding this year, depending on the bonds in their portfolios.
In the second quarter, the average junk bond fund had a positive “total return” of 1.5 percent, according to Morningstar Inc. Total return includes a fund’s interest earnings, plus or minus the net change in principal value.
So for junk funds, the interest income earned in the quarter more than offset the drop in principal value.
But the first-half return for the average junk fund was a negative 2.1 percent, meaning principal losses exceeded interest earned.
Likewise, bank-loan funds, which buy pieces of corporate loans (often of high-risk companies), rebounded 4.5 percent in the second quarter, but still had a 1.6 percent loss for the half because of their dive in the first quarter.
By contrast, the average fund that owns long-term government bonds had a negative total return of 2.9 percent in the quarter but still was up 0.9 percent for the half.
Given bond funds’ struggles, it’s no wonder that many safety-conscious investors simply are sticking with money-market mutual funds, which have very low risk of principal loss. Money funds now pay an average annualized yield of 1.89 percent, according to iMoneyNet Inc.
Money market funds took in a net $314 billion in fresh cash in the first five months of this year, while bond funds’ net inflow was $80 billion, industry data show.
But one challenge looms large for all income-focused investors: inflation — and how the Federal Reserve and other central banks respond to it.
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To our readers: This report on 2nd-quarter mutual fund and stock performance replaces the usual Monday Business section. The regular Monday news and features will return next week.