Investors are finally getting religion about the slide in interest rates--and why not, when the preacher urging them on is the Federal Reserve Board?
The Fed eased credit Friday for the third time in three months, allowing the federal funds rate--a key rate that banks charge each other for short-term loans--to fall to 7.25% from 7.5%. As recently as July, that rate was 8.25%.
Friday’s Fed move sparked an explosive Treasury bond rally and set the stage for a continuing drop in interest rates through year-end. The yield on the 30-year T-bond, the benchmark for long-term interest rates, plunged to 8.19% Friday from 8.33% Thursday as investors snapped up bonds to lock in yields.
Many investors who avoided T-bonds when they yielded 9% in September now are afraid that if they don’t grab current yields, 7% or worse is just around the corner. There are memories of 1982, the last time the Fed desperately slashed interest rates to keep a recession from turning into a depression. In that year, T-bond yields plunged to 10.5% from 14.5% as the Fed pumped money into the financial system.
Is the bond rally just beginning? Doug Brown, government bond trading chief at Wedbush Morgan Securities in Los Angeles, says that Friday definitely marked a turning point for some investors. “People are starting to believe,” he says.
Investors who are living off interest from short-term cash investments are now fearful that their income will drop sharply next year if interest rates continue to fall, he says. “So we’re hearing now from people who want to go further out” the investment spectrum, to lock in longer-term bond yields, Brown says.
So far, however, the rally has largely been limited to safe Treasury bonds, notes Rick Cullen of Cullen, Fortier Asset Management in Woodland Hills. High-quality long-term corporate bond yields have fallen only to about 9.15% from 9.6% in September, and lower-quality corporate bonds have barely budged, yielding about 10.5% on average.
Because the spread between T-bonds and corporate bonds has widened dramatically, Cullen believes that the best buys are in the corporate bond market. He’s been picking up selected issues, anticipating that the next big bond rally will be led by the corporate sector. Although the Middle East situation remains a concern, Cullen says, “I think we are closer to the bottom (in bond prices) than we are to the top.”
Some of his recent purchases for his $80-million investment fund include Litton Industries bonds, yielding about 11.5% and maturing in 1995; restaurateur Shoney’s Inc. bonds, yielding about 12% and callable in 1994, and Warner Communications bonds, yielding about 11% and maturing in 1994.
Cullen stresses that investors would be foolish to pick up any corporate bonds of questionable quality; he isn’t dealing in high-risk junk bonds, he says. “You have to do credit analysis; you can’t just wander into this market,” he says.
L. David Tisdale, president of the Starbuck, Tisdale & Associates investment firm in Santa Barbara, also finds some corporate bond yields extremely attractive. “We’re trying to get as high-quality as we can in the non-Treasury area,” he says, such as paper issued by General Motors Acceptance Corp. When you can buy high-quality corporate bonds yielding two percentage points over Treasury bonds of the same maturity, Tisdale says, “I think that’s well worth the risk.”
Investors who are intrigued with corporate bond yields are best advised to invest via bond mutual funds, which lower your risk through diversification. Most major mutual fund families have long offered high-quality corporate bond funds that invest only in financially solid companies. Those funds took a back seat to corporate junk bond funds in the 1980s, as investors sought sky-high yields without regard to the risks.
But now, of course, quality and safety are “in” again. That’s the reason investors are so enamored of Treasury bonds. And money managers like Cullen and Tisdale believe that, in time, investors will renew their faith in the credit quality of strong American companies, leading to a much stronger rally in those bonds.
What if you’d just as soon stay with ultra-safe Treasury bonds? Most investment advisers still suggest buying Treasury securities maturing in 10 years or less, rather than going out 30 years. As of Friday, 10-year T-notes yielded 8.03%, versus 8.19% for the 30-year bonds. The extra 0.16 percentage points in the 30-year bond isn’t enough to make it worthwhile, most experts say.
Before you make any decision to lock in longer-term rates, remember: There’s no way to be sure that interest rates are indeed in a prolonged decline. They could soar again if war breaks out in the Middle East. The best advice is to spread your money over bonds and money-market investments of varying maturities so that you’ve hedged your bet no matter what happens.