With recession on most economists’ calendars for the first half of 1991, the outlook for bonds is good.
U.S. Treasuries, the safest investment available, historically do well in economic slumps as the stock market, real estate and other investments appear at their riskiest.
Economists predict that rallying bond prices will push the yield for the 30-year Treasury bond down to around 7.5% in 1991. The benchmark bond has been yielding around 8.3% in recent days and was above 9% as recently as early October.
The bond market has been rallying since the Federal Reserve early last month signaled that it was ready to lower interest rates to increase economic activity.
The Fed cut its target for the federal funds rate three times in December--in 0.25 percentage-point increments--to 7%. The central bank also lowered the discount rate by 0.50 percentage point to 6.5 percent.
The federal funds rate is the overnight loan rate between banks. The discount rate is the Fed’s loan fee to banks.
Two factors could strongly affect bond prices and their yields. The Persian Gulf crisis continues to be unpredictable, and Federal Reserve policy, as always, will influence bond yields.
There is strong pressure from Washington for the Fed to ease more aggressively. However, some on Wall Street are concerned that lowering interest rates too much would aggravate inflation, which erodes the value of fixed-income securities such as bonds.
“If the Fed moves too quickly, inflation expectations could rise,” said Lawrence A. Kudlow, chief economist at Bear, Stearns & Co. As it has thus far, the Fed should take its cue from the bond market and gold prices, according to Kudlow. Falling gold prices and rising bond prices should precede another Fed easing move, he said.
Kudlow expects long-term bond yields to fall to 7.6% by midyear and fluctuate around there for the rest of the year.
John Lonski, senior economist at Moody’s Investors Service Inc., says long-term interest rates could fall to 7.35% if core inflation--excluding food and energy--is significantly reduced.
“Increased government borrowing will put pressure on bond yields, but cutbacks in private-sector borrowing will ensure an adequate amount of funds,” he said. Also, banks and others will put more money in Treasury securities.
The safety of Treasury bills, notes and bonds historically attracts investors wary of the risks inherent in investing in an economic downturn. Treasury securities are seen as safe because they are backed by the government. If the federal government couldn’t pay its debts, money wouldn’t be of much use because the economy would be in shambles.
Corporate bond prices are expected to follow Treasury bonds. The fortunes of corporate borrowers and their ability to repay debt will be helped if interest rates go lower.
“The corporate market is basically trying to determine the outlook for profits, cash flows and credit worthiness--there’s nothing better than lower interest rates,” Kudlow said.
Junk bonds will probably still be in the dumper in the coming year.
In 1990, $22 billion in corporate bonds--issued by 91 companies--defaulted, according to preliminary numbers compiled by the Bond Investors Assn. The nonprofit group that tracks bond defaults expects $25 billion worth of corporate debt to default in 1991.
The economic slowdown, combined with lack of demand for new issues of junk bonds, is causing the spiraling default rates, said C. Richard Lehmann, Bond Investors Assn. president.
Before the collapse of the junk bond market, issuers could avoid default and restructure their debt by floating new bonds. Now that junk bond buyers have all but disappeared, that option is gone.
The trend lately has been for issuers to give up equity to bondholders to entice them to agree to a restructuring.
Some investors, most notably TWA Chairman Carl C. Icahn, have been selectively buying junk bonds with hopes of picking up a profit in a debt-for-equity swap.