Safe mode nets gains for bonds

‘Better safe than sorry” turned out to be the winning motto for many mutual fund managers and their investors, as 2007 made a sudden transformation from an easy-money era to a painful credit crunch. When the debt markets seized up in the wake of the housing downturn and mounting mortgage defaults, bond funds that shunned risky sub-prime securities in favor of government IOUs and other relatively safe holdings notched solid returns.

“Those that held sub-prime derivative securities were the big losers and those that didn’t were big winners,” said superstar fund manager Bill Gross of Pacific Investment Management Co. in Newport Beach.

The Pimco Total Return fund that Gross runs scored a gain of 8.6% last year, a higher return than 90% of its peer bond funds -- and better than the 6.4% gain of the average stock fund -- after Gross’ gamble that the housing crisis would force the Federal Reserve to cut interest rates paid off late in the last third of the year.

For the fourth quarter, Gross’ fund returned 3.8%.

Overall, investors in funds that own high-quality bonds fared well in the fourth quarter, lifting their returns for the year, as most retail mutual funds steered clear of sub-prime-related holdings and didn’t otherwise take outsize risks in search of extra yield. That strategy protected the funds from the massive redemptions and forced fire sales of troubled assets that struck some institutional offerings as well as some hedge funds, experts said.

“Most bond mutual funds avoided trouble,” Morningstar senior analyst Scott Berry said. “For most bond investors it was a good quarter.”

Long-term Treasury funds were the best-performing bond sector in the fourth quarter, boasting an average total return of 6.5%, and returned 9.8% for the year, according to data from Morningstar Inc.

Total return includes interest income and price changes in the market values of a fund’s bond positions.

Investors sought refuge in Treasury bonds as the housing crisis and credit crunch deepened in the final months of 2007, boosting funds that already held large Treasury positions.

Intermediate-term Treasury funds rose 2.8% in the quarter and 6.1% in 2007, while short-term Treasury funds advanced 2% and 5.9%, respectively.

Still, the gains weren’t uniform, and some individual funds and sectors had poor showings.

What’s more, experts said, the Treasury rally undoubtedly helped some funds overcome losses on holdings of sub-prime and high-yield debt.

“The trend lower in Treasury rates has at least over the recent term masked some underlying poor relative performance,” said Andy Phillips, co-head of U.S. fixed-income at BlackRock Inc.

More than in the recent past, experts said, bond fund performance varied widely in late 2007.

From the start of 2005 through the first half of 2007, the chasm between the returns of the top-performing and worst-performing high-quality bond funds was always less than 15 percentage points, Morningstar said. That swelled to 30 points in the third quarter. In the fourth quarter, the gap widened further.

“The performance of fixed income was widely disparate,” Gross said. “There were huge extremes within the bond manager group.”

Some of the most glaring underperformance was in ultrashort funds and bank-loan funds, which individual investors had prized in recent years because their yields topped super-safe money-market funds.

Fund companies pitched ultrashort funds as credible substitutes for money funds.

In a 2006 mailing to customers, for example, Charles Schwab Corp. boasted that its YieldPlus fund “offers higher potential returns than money market funds with only marginally higher risk.”

But ultrashort funds and bank-loan funds fell victim in varying ways to the sub-prime crisis. Ultrashort funds were down fractionally for the quarter and up a meager 2.4% for the year, while bank-loan funds were off 0.6% in the quarter and up only 1.1% for the year.

Schwab’s YieldPlus fund sagged 1.2% last year, and some other ultrashort funds got walloped. State Street Global Advisors’ SSgA Yield Plus fund sank 13.8% for the year, while the Fidelity Ultra-Short Bond fund dropped 5.1%.

Some investors “clearly took a lot more credit risk than [they] thought they were getting into,” said Dave MacEwen, head of bond investing at American Century Investments.

The performance of bond funds also underscored investor worries about the economy.

High-yield, or “junk,” funds mostly declined in value in the fourth quarter, a sign that investors expected the economy to weaken and corporate bond defaults to rise. The average junk fund fell 1.4% in the quarter and was up just 1.5% for the year.

On the flip side, funds that buy inflation-protected bonds were the second-best sector in the quarter, a sign that investors fear the specter of stagflation, the toxic brew of rising prices during an economic slowdown.

Though Treasury holdings gave many bond funds a lift in the fourth quarter, managers say yields on securities have dipped so low that they’re no longer a good bargain.

Instead, many managers are looking to municipal bonds, which they say were hit too hard as investors fled to Treasuries last year. Many munis offer tempting yields with limited credit risk in a softening economy, they say.

“If there’s one place in the fixed-income world that looks like it’s attractive to go into, it’s the whole spectrum of tax-free bonds,” said Jim Swanson, chief investment strategist at the MFS fund group.

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walter.hamilton@latimes.com