Bond Rally’s Great, But Pros See End Soon
Two things are apparent at this stage of the Great Bond Rally of 1993:
* Many bond professionals believe that interest rates are close to bottoming out, and that the risk of buying bonds now is extremely high.
* Many individual investors don’t give a hoot what the pros think, because earning 5% to 8% on bonds still feels a lot better than earning 3% or less at the bank.
So far, the individual investor has looked considerably smarter than the pros. While many of the alleged experts thought it would be very difficult for the yield on 30-year Treasury bonds to fall below 7%, that barrier was crashed with ease in mid-February.
Now, at a 6.74% yield on that benchmark T-bond (from which other long-term interest rates take their cue), individuals continue to pour money into bonds and bond mutual funds--essentially saying that they believe these still are attractive rates.
But the pros insist that, at best, the T-bond yield can drop to 6.5%. And from there, many experts are betting on a rebound in rates this spring or summer. If you want to buy bonds, they say, you should wait. If you can’t be patient, then buy a little now--but spread most of your investment over the next six months.
“I suspect we’ll probably see 7.25% again” by summer on the T-bond, says Tom Sowanick, one of Merrill Lynch & Co.’s top bond strategists in New York. Yet he also admits that “we’ve got egg on our face” for having turned cautious on bonds three weeks ago.
Since fall, the right bet on bonds clearly has been to buy and hold. As market interest rates have tumbled--thanks to the weak world economy and optimism about President Clinton’s long-range plan to cut the federal budget deficit--bonds paying attractive fixed rates have appreciated in value. So bond owners have earned their interest, plus a nice capital gain.
As the accompanying table shows, total returns on most types of bond funds since Nov. 30 have been in the 5% to 6% range. That’s a hefty return for a mere three months. In contrast, the stock market has gained about 4% in that period, including dividends.
If you’re convinced that interest rates will stay level or fall further, buying bonds today makes perfect sense--especially if your alternative is 2.7% in a money market fund, an all-time low. You can lock in a 5.1% annualized yield on a five-year Treasury note. That won’t set the world on fire, but it’s almost double the money fund yield.
But what if market interest rates rise instead of fall in the months ahead? Or what if money fund yields start to climb? Either way, an investor stuck with a 5.1%, five-year T-note suddenly might not feel so smart.
And if bond yields jump sharply, and new five-year T-notes pay 5.5% by summer, your 5.1% note will be worth less than what you paid. “Total return” in bonds works both ways: Depreciation of principal can negate interest earnings.
The bearish bond pros are simply arguing that, given how far bond yields have already fallen, there’s high risk in locking up too much of your money at current rates.
After all, no market goes straight up or down forever. Even if individual investors are content to stay put in bonds, experts note that the legion of professional traders out there is ready to make this market rock and roll.
Indeed, “the fundamental strategic question that investors will face over the next 18 months will be, ‘When to sell bonds?’ ” argues David Shulman, investment strategist at Salomon Bros. in New York.
The first hint of traders’ itchy trigger-finger mentality surfaced last Friday, when the government shocked Wall Street with news that the economy generated jobs in February at the fastest pace in nearly four years--though most of those jobs were part-time.
Bond yields surged after the report, because any indication of a strong economy suggests that the price of money--interest rates--should be going up, not down. A healthy economy also raises the specter of higher inflation, which is the No. 1 enemy of the bond market because inflation erodes fixed-rate returns.
But to the surprise of many pros, long-term bond yields quickly eased Friday, and closed only slightly above Thursday’s levels. The 30-year T-bond yield, for example, shot from 6.73% Thursday to 6.83% Friday morning, then fell back to close Friday at 6.74%.
Bond buyers say the market’s strength in the face of the February employment report was an encouraging sign. But to David Jones, economist at bond dealer Aubrey G. Lanston & Co. in New York, Friday’s rally was a measure of how desperate buyers are to justify their bullish stance.
That desperation to paint the economy as anemic is most evident in the White House itself. President Clinton and his advisers try to spin every economic statistic as negative, Jones says, because the Administration badly wants interest rates to keep dropping, to offset the depressive effect of the proposed corporate and personal tax hikes.
John DeAngelis, a bond trader at CRT Government Securities in New York, concedes that he and most of his peers were stunned by the bond market’s recovery Friday. But he, too, cautions that the strength of the February employment report may soon come back to haunt the market.
At the very least, the market decided Friday that there’s no chance the Federal Reserve will ease short-term interest rates again. Yields on six-month Treasury bills jumped from 3.08% Thursday to 3.18% Friday. If short-term rates creep higher, that too will make it tougher for long-term rates to move down.
Should the small investor care about the technical points of bond trading? Admittedly, most bond pros have an agenda different than that of small investors. The pros are market timers. The individual bond investor is mostly just interested in decent interest income.
While Merrill’s Sowanick believes that interest rates will move up in coming months because of inflation fears, a better economy and doubts about federal budget cuts, he also expects sluggish growth to dominate worldwide for the next couple of years.
And that means “interest rates will probably go lower than a lot of us want to believe” long-term, he says.
Still, within any big-market trend there are many smaller up and down waves. The argument for waiting to buy bonds is that the down wave begun last fall is about to give way to a significant, if temporary, up wave.
On Wall Street, “buy low, sell high” remains the best advice going--in bonds as well as stocks.
How Bond Funds Have Prospered Just how much money have bond mutual fund investors made as interest rates have tumbled in recent months? Here’s a look at fund returns by category for three recent periods. Returns include interest earned plus share price appreciation.
Avg. total return thr Bond fund category Feb. Yr.-to-date California municipal, long-term +4.23% +5.33% General municipal, long-term +3.84% +5.01% High-quality corporates, long-term +2.24% +4.43% High-quality corporates, 5- to 10-yr. +1.82% +3.82% High-quality corporates, 1- to 5-yr. +0.98% +2.15% Junk corporates +1.86% +4.63% Lower-quality corporates, long-term +2.31% +4.49% Mixed bond funds +1.73% +3.76% World bonds +2.06% +3.42% U.S. government, long-term +1.67% +3.48% U.S. government, 5- to 10-yr. +1.65% +3.52% U.S. government, 1- to 5-yr. +0.95% +2.20% GNMA securities +1.00% +2.54% Adjustable-rate mortgages +0.49% +1.03% Money market funds +0.20% +0.43%
ough Feb. 26 Bond fund category Since 11/30 California municipal, long-term +6.73% General municipal, long-term +6.26% High-quality corporates, long-term +6.17% High-quality corporates, 5- to 10-yr. +5.30% High-quality corporates, 1- to 5-yr. +2.97% Junk corporates +6.00% Lower-quality corporates, long-term +6.22% Mixed bond funds +5.20% World bonds +4.42% U.S. government, long-term +5.09% U.S. government, 5- to 10-yr. +4.94% U.S. government, 1- to 5-yr. +3.23% GNMA securities +3.88% Adjustable-rate mortgages +1.64% Money market funds +0.67%
Source: Lipper Analytical Services Inc.
