NEW YORK -- A bond by any other name may stink.
Treasury bonds have outperformed equities this year, and in response, many investors have dutifully switched at least some of the assets in their portfolios from stocks to bonds.
Yet without realizing it, they may be buying a few rotten apples along with the good ones.
Treasury bond funds are allowed to invest as much as 35 percent of their assets in corporate and junk bonds and mortgage-backed securities, which are riskier and not backed by the full faith and credit of the U.S. government.
"Not all bonds are created equal," said Sung won Sohn, chief economist at Norwest Corp. in Minneapolis. "You have to be the most beautiful, and here the second or third runners-up don't count. If you're not investing in the highest-grade bonds, in many cases, you've lost money."
The distinction has become important lately.
Since July 16, U.S. Treasury bonds have produced a total return of 5.12 percent, compared with negative 11.18 percent for the Standard & Poor's 500 stock composite.
But non-government-backed bonds, which have been hit hard by a credit crunch in corporate lending and a flood of mortgage refinancings, haven't done nearly as well. Adding them to a government-bond portfolio can put a big crimp in returns.
Over the same period, the total return on investment-grade corporate bonds was 2.57 percent. It was minus 11.10 percent for non-investment grade junk bonds, and 0.91 percentage point for adjustable-rate mortgage-backed securities.
These markets already had been lagging Treasury securities when investors began paring their stock holdings in late July, after Japan found it impossible to deny that it was a serious recession. In August, Russia shocked world financial markets by devaluing the ruble and writing down its debt to 15 cents on the dollar, and the Dow Jones Industrial Average plunged nearly 20 percent from its July 17 peak of 9,337.97.
September brought the hedge fund debacle: the near-death and $3.6 billion bank bailout of Long-Term Capital Management, a risky hedge fund; Ellington Capital Management's dumping of a huge portfolio of mortgage-backed securities; and the disclosure of serious problems at another high-risk investment fund, D.E. Shaw.
The Federal Reserve responded to the disruption in world markets by easing interest rates, first on September 29 and again on Oct. 15, pushing rates on Treasury securities to unprecedented lows.
Yields on non-Treasury securities also fell, but not as fast as those on Treasury bonds. As a result, their yield spread over Treasury bonds widened sharply, lowering their market value.
The yield spread between investment-grade bonds and the 30-year Treasury, for example, widened to nearly 1.73 percent as of Oct. 13 from 1.49 percent Sept. 29. Over the past 15 years, that spread has averaged 1.16 percent, said John Lonski, chief economist at Moody's Investors Service.
The spread for junk bonds widened over the same period to 7.32 percent from 5.98 percent. The 15-year average is 4.5 percent.
The mortgage-backed securities market has special problems. Many homeowners have taken advantage of the lower interest rates by refinancing their mortgages, prompting the early retirement of many mortgage-backed securities and forcing their holders to reinvest in lower-yielding instruments.
As a result, yield spreads on mortgage-backed securities have ballooned to 1.69 percent from 1.15 percent at midsummer.
Rao Chalasani, chief investment strategist at Everen Securities in Chicago, believes the spread widening is overdone and not warranted by any decline in the health of corporate balance sheets.
"It has more to do with leverage in the financial system than any fragility in the economy," he said.
Overdone or not, the poor performance of non-Treasury securities can take a severe bite out of returns to investors who might not be aware they even own them.
"This underscores the need for investors to carefully read the prospectus before they invest," said Chris Wloszczyna, spokesman for the Investment Company Institute.