Black fund watch: a bull market ... in bonds?

By now you've heard investing experts go on about what had been a bull market in stocks. At the same time, there's been another, less-publicized bull market taking place in bonds. In fact, bond funds have turned in a steady rally for much of the year.

That's good news for Mark Lay, co-manager of MDL Broad Market Fixed Income Fund, which had a well-timed launch last November. "Historically, bonds give you three-quarters of the return of stocks at half the risk."

This year has been quite fine for Lay's fund, which has amassed $7 million in assets. As of press time in August, it had posted a total return of 4.9% for the first half of 1998. That's ahead of its bond fund peer group, the Lehman Government/Corporate Bond index, which posted 4.43% for the same period, according to Morningstar, a Chicago firm that tracks the industry.

For longer-term performance, look at the MDL institutional bond portfolio. Lay has managed it for pension funds and other large clients since 1993; it's an exact replica of his bond mutual fund. That portfolio has done quite well, with a cumulative total return of 60.93% for the five-year period. That's more than 10% above its benchmark, the Lehman index, which had 50.3% for the same period.

Lay gets his returns in a nontraditional way. Many general bond fund managers rely on higher-yielding corporate bonds, junk bonds and mortgage-backed securities to add value and stronger total returns to their portfolios. Lay, 35, and his co-manager Edward Adatepe, 39, have a scant 2% in corporate bonds and 4% in mortgage-backed securities. Instead, the two have a full 94% of the portfolio anchored in safe U.S. Treasury bonds, the kind that normally bore mutual fund managers.

"Typically, U.S. Treasuries outperform corporate bonds and mortgage-backed securities when the economy slows," he says, explaining the portfolio's high Treasury concentration. That's just what happened earlier this year.

Instead of fishing for riskier debt, Lay gets results by being more aggressive -- that is, making a larger bet with his entire portfolio. That means shifting the portfolio's asset weighting depending on the interest rate outlook. Remember, bonds pay a fixed yield, or interest rate. Yet, when interest rates slide, bonds often appreciate in value.

Lay thinks rates are heading to substantially lower levels. The yardstick, the 30-year U.S. Treasury, currently yields 5.62%; Lay thinks that could sink to as low as 4.5% by next year. With 22% of his bond holdings in longer-term bonds as of July 15, Lay is making a large bet on his hunch. "That's a huge drop. We have the potential to see the bond market up 10% or more," he says.

Lay continues to be bullish on bonds for good reason. For one, the Asian economic crisis and Russia's economic problems continue to have an impact on the global and U.S. economies, lowering corporate profits. Those circumstances should send many institutional investors to bonds as a safe haven. Another factor that bodes well is low inflation. Lay expects inflation to remain under 2% over the next 12 to 24 months. Finally, since the U.S. government has done away with its budget deficit and is running at a surplus, it's borrowing less from investors. That means fewer bonds will be issued in the future, thus driving up the demand for them.

Lay honed his skills on Wall Street, where he traded foreign exchange futures and government bonds at Citicorp Investment Bank and Dean Witter for 10 years before venturing out on his own in 1993. He set up shop in Pittsburgh, just 15 miles from where he grew up. Lay consulted with brokerage pioneers, including Wardell Lazard and John Utendahl, before striking out on his own. "They both drove home that you must compete strictly on performance to succeed," he recalls. Now MDL manages $680 million for clients like the Atlanta Police Department, State of Pennsylvania State Workers' Insurance Fund and Ohio State University's endowment fund.

Name: MDL Broad Market Fixed Income
Managers: Mark D. Lay and Edward Adatepe
Phone: 877-MDL-FUNDS
Sales Charge: None
Minimum Initial Investment: $500
Annual Expenses: 0.009%

Top three holdings:
U.S. Treasury 6.125% as of November 2027
U.S. Treasury 7.25% as of May 2004
U.S. Treasury 7.5% as of May 2005