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When I was test runnung the engine in my yard with the hose hooked up for water, I noticed water coming out of the bellows. The transom does not leak. The engine does not over heat. Is this bad or not.

Was it the bottom bellows???? If so that is the exhaust bellows and if you look at the bottom they are perforated or vented (holes made in them) they are designed that way to reduce noise and all is good (you "could" actually remove that bellow and never see a problem other than noise. If you just bought this boat and and/or you are unsure of past maintenance (imho) a bellows replacement should be maintenance you'd like to do sometime soon (just to know when they were bone and have some piece of mind about that. (imo) if one bellows looks bad (hard, brittle, ripped) they ALL are (or will soon be).

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'90 Horizon 220 5.8

It is the bottom. Thanks

How often should the bellows be replaced?

the lower exhaust bellows you really don't have to worry about as long as its in one piece but the upper one for the driveshaft is very important and keeps water out of the boat and driveshaft area...this one probably should be inspected yearly and replaced about every 5 years...

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88 Four Winns 200 Horizon
4.3 OMC Cobra-4bbl
2002 Walker Bay 10/2012 Suzuki 2.5
2008 Walker Bay 8

1998 Jeep Grand Cherokee 4.0/Selectrac
2007 Jeep Grand Cherokee 5.7 Hemi/Quadradrive II