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June 27, 2003, 7:46 p.m. EDT

Risk rewards bond-fund investors

Emerging market and high-yield debt are quarter leaders

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By Rachel Koning, CBS.MarketWatch.com

One of six stories in our quarterly funds wrap-up. See also: Stock Funds Rally ; Quarter's Top Fund ; Bear Funds Mauled .

WASHINGTON (CBS.MW) -- Investors who funneled money into emerging-market and high-yield bond funds were rewarded for their nerviness, reaping second-quarter returns at least twice as high on average as lower-risk government-bond funds.

Taxable bond funds rose 3.63 percent this quarter through Thursday, while tax-exempt funds are up 2.43 percent, according to preliminary data supplied by mutual fund tracker, Lipper.

Put off by U.S. Treasury yields at 45-year lows, investors were enticed to riskier classes by a drop in high-yield issuer defaults.

At the same time, continued stability for category bellwether Brazil and commodity price gains combined to fatten emerging debt returns, said Brad Sweeney, senior analyst with Morningstar.

Emerging debt funds leaped 11.4 percent in the April-to-June quarter to lead all taxable fixed-income fund sectors. High yield or "junk" bond funds gained 8.5 percent on average in the same timeframe.

Nine of the second-quarter's top 10 performers are classified high yield or emerging debt.

Multi-sector income funds finished third with a 6.3 percent gain, while so-called target-maturity funds added 5.56 percent.

General U.S. Treasury funds returned 3.03 percent, while the highest rated corporate bond funds returned 3.01 percent and slightly riskier "BBB" rated corporates earned 4.34 percent. Global income funds brought investors a 5.05 percent return.

No fixed-income funds saw a negative quarter, but among the laggards were mortgage funds with a slender 0.65 percent gain amid a flurry of mortgage prepayments as interest rates tumbled. GNMA funds returned 0.57 percent and adjustable rate mortgage funds added just 0.37 percent for the period.

Short-term U.S. Treasury and government funds returned 0.67 percent and 0.47, respectively and ultra-short obligation funds brought up the rear at 0.24 percent.

In fact, taxable bond funds as a group only saw average weekly declines in the final two weeks of the quarter as yields plunged further in anticipation of a half-point Fed interest-rate cut. The Fed delivered a tamer quarter-point cut on June 25.

Corporate clean-up

For the same reasons that influenced the quarter's returns, high-yield funds are up 14.62 percent so far this year, while emerging fund managers can boast returns of 20.28 percent for their group.

Sweeney also explained that high yield appears to be acting independent of equity returns - although stocks too have gained on the year - with focus on bond-sensitive fundamentals such as improved company balance sheets, cost-cutting and debt reduction.

And according to a report from Fitch, the default rate of U.S. junk bonds fell to 11.8 percent in May, down from both the 13.5 percent rate in April and the 16.4 percent rate at the end of last year - the highest in a decade.

The high-yield advance "is not necessarily related to the U.S. economy," which is still causing investors to fret about profitability and hiring, Sweeney said.

The class A shares of Fidelity Advantage High Income high-yield bond fund /zigman2/quotes/207944830/realtime FAHDX -0.28% earns top ranking through Wednesday, returning 16.42 percent. It's up nearly 28.9 percent so far this year.

Christopher Garman, chief high yield strategist with Merrill Lynch, warned that despite the good news to be found for risk-takers in the falling junk default rate, the rate of deceleration from the default peak hit in January 2002 is among the slowest in recent history.

He's cautious on high yield debt over the near term considering a spread premium to Merrill Lynch's historical bond model that's too dependent on a domestic economic recovery yet to materialize.

Analysts agree that over a longer timeframe, the high-yield category continues to bear the scars of the tech bubble burst and corporate accounting scandals. Analysts remind of the risks this category brings with its rewards.

"One cautionary note for investors is that although high-yield funds offer good value relative to Treasury funds in terms of yield, by historical standards the yields on junk bond funds are close to their lowest levels in 15 years," Lipper analysts said in a research note.

GMO fund leads emerging

Ranking third overall and leading its category, the Grathan, Mayo, Van Otterloo & Co. [GMO] Emerging Country Debt III fund /zigman2/quotes/204250328/realtime GMCDX -0.57% advanced 14.80 percent, according to Lipper figures as of Wednesday. It's up just over 23.97 percent since the start of the year.

Lipper analysts said even late-quarter profit-taking for emerging debt and a Brazilian central bank cut to its benchmark Selic rate did little to derail a robust quarter.

Sweeney said the U.S. dollar's weakness does not really impact emerging market performance because most funds are denominated in U.S. dollars and not subject to foreign exchange risk.

Emerging debt remains up a "staggering" 34.07 percent over the past 12 months, the Lipper analysts noted.

Top 10 performing Q2 taxable bond funds

Compare funds

Source: Lipper. Data through Thursday, June 26. Largest class shares only.

US : U.S.: Nasdaq
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Rachel Koning is a reporter for CBS.MarketWatch.com in Washington.

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