Recession Is Good News for Bond Portfolios

Recessions are like house guests. Both tend to arrive when you’re not ready and stick around longer than you want.

Now that the recession is here, the next question is when will it end. Bond fund investors hope the answer is: not too soon.

Their reasoning is simple. Interest rates usually move lower during periods of economic contraction, and that helps push up bond prices. Several more months of economic weakness this time around would tend to make fixed-income funds more attractive, while a sudden, sharp recovery could send most bond portfolios reeling.

Consider what happened during the last recession in the early 1980s. When the economy slumped badly in ‘82, compressing interest rates from unusually high levels, long-term government bonds surged 40% for the year, according to Ibbotson Associates of Chicago. But in ‘83, with the economy picking up steam and rates stabilizing and then rising a bit, those same bonds delivered a total return of under 1%, including interest, which means prices actually fell.

While hardly anyone predicts the economy will switch onto a fast track any time soon, there’s ample disagreement about prospects for the economy and interest rates--and what it all means for fixed-income investments. If you have a lot of money committed to bond funds, now might be a good time to rethink your position.

For example, Palomba Weingarten, head of the Pilgrim Group, a Los Angeles fund family, believes that the trend to lower interest rates has just about run its course. “I don’t expect rates will spike higher from here, but I wouldn’t make a play on lower rates either.” At the moment, she cautions against holding fixed-income funds with lengthy average maturities--which she defines as seven years or more--since the prices of long-term bonds react more noticeably to any change in interest rates.

John L. Hague, a vice president with Pacific Investment Management Co., a Newport Beach firm overseeing $30 billion in assets, thinks that the economy will stay weak at least through the first half of this year. The long-term deflationary forces that were triggered by the stock market crash of 1987 remain in force, he says, which augurs well for further rate declines. Within the next year or two, long-term Treasury bonds could rise in price to where their yields drop to the 7.5% to 7.75% range, Hague predicts. That compares to about 8.3% currently.

Despite this cautiously bullish outlook, Hague sees no reason for bond investors to take undue risks. His firm sticks with government debt and higher-rated (“investment grade”) corporate bonds and, like Weingarten, avoids excessively long-term issues. “By not making extreme bets,” he says, “you avoid the potential for big mistakes.”

On the other hand, big bets are in the game plan devised by Paul E. Suckow, director of fixed-income securities for Oppenheimer Funds of New York. In short, he’s optimistic about the prospects for mutual funds that hold junk issues. “There are some pretty spectacular values among high-yield bonds right now,” he says.

Suckow doesn’t think the economy will recover so quickly that it will bail out tottering, over-leveraged corporations. Rather, he believes that prices have generally slumped so much since ’89 that aggressive investors can afford to take some calculated risks with junk securities, especially when held within a diversified, professionally managed vehicle such as a mutual fund.

It’s worth noting that junk prices respond largely to changes in the issuing company’s fundamentals and the general economic climate, although interest rates also exert an influence.

At current depressed prices, junk bonds offer yields to maturity in the 13% to 18% range, Suckow says. At those rates, investors should come out in good shape even if their fund has some bond holdings that default.

Then there’s the potential for price appreciation. Most of the people who have wanted to get rid of their junk bonds have already done so, Suckow believes. “The bottom of the market comes when investors and brokers say they’ll never buy another high-yield bond again.” The nadir occurred last fall, he argues.

Since then, the high-yield market has rallied, with junk bond funds showing total returns of about 8% on average during the first two months of this year. One big positive, Suckow says, has been the stock market surge, which allows over-leveraged companies to issue new shares at better prices and use that money to retire debt. As a bonus, junk bond funds have tax-loss carry-forwards from the past two years that can be applied to future capital gains, thereby sheltering some appreciation.

As a negative, corporate defaults are still running at an alarming rate. The Bond Investors Assn. of Miami Lakes, Fla., expects corporations to stop making payments on $50-billion worth of lower-rated debt before 1992, following what it says were $24.6 billion in defaults last year. That’s why it’s important to stick with high-grade junk bonds and bond funds. “Just like stocks, you know some won’t do well,” Suckow admits.

Weingarten agrees that at current valuations selected junk bonds might offer good long-term potential. But she cautions investors to understand what they’re getting into. “Look at a high-yield fund as an equity fund with a high coupon.”

In short, junk bond portfolios, like stock funds, make sense for people who can tolerate some risk and think the economy will improve soon. Otherwise, stick with a fund that holds higher-quality corporate debt or government issues. These types of bonds, Hague predicts, should continue to post annual returns of at least 8.5% to 9% or so--even more if the recession stays around longer than anticipated. “It’s not too late to buy,” he says.

JUNK ON A ROLL Junk (high-yield) bonds and the mutual funds that hold them have had an impressive run in recent weeks, sparked by hopes that the recession might be near bottom. A healthier economy would improve the chances that weak, over-leveraged corporations could avoid defaulting on their debt. This chart shows that junk bond funds have recovered recently. They returned about 8% on average during the first two months of 1991, compared to losses of 2.4% and 11.5% for ’89 and ‘90, respectively.