A Slight Whiff of Higher Rates Gives the Weak-Hearted a Scare

Interest rates aren’t suddenly going to the moon, despite the economy’s apparent new head of steam.

But after three years in economic limbo, investors so far appear ill-prepared to cope with the transition to stronger growth--and with it the inevitable gradual rise in rates from their recent 20- to 30-year lows.

That suggests there’s more turmoil ahead in the bond market, as marginal investors--especially skittish bond mutual fund owners--are shaken out after this year’s spectacular rally.

Stocks could suffer more pain as well. But Wall Street pros believe any losses in that market will eventually be recouped, in part because some of the investors leaving bonds may well find a new home in stocks.

Investors’ interest rate Angst was evident last week, as stock and bond markets convulsed after reports showing rising home sales, healthy orders for manufactured goods and a pickup in job growth.

The 30-year Treasury bond yield, the benchmark for long-term interest rates, ended the week at 6.20%, its highest level since Aug. 24 and a rise of a quarter-point for the week.

In the stock market, the Dow industrials tumbled a total of 73 points Wednesday and Thursday, before rebounding 18.45 points on Friday to 3,643.43.

Most Wall Streeters insist that fears of a sharp jump in interest rates are absurd, because the current pickup in the economy is likely to be followed by a slowdown early in 1994--when higher federal income tax rates kick in for upper-income earners and for many retirees.

What’s more, despite the gain of 177,000 jobs nationwide in October, hiring isn’t expected to accelerate much because businesses don’t want to boost costs in a still-iffy economy. Without job growth, it’s unlikely we’ll see a sustained healthy rise in consumer spending that would put significant upward pressure on the cost of money.

“It’s terribly premature for rates to be backing up,” declares Steven Einhorn, investment strategist at Goldman Sachs & Co. in New York.

The immediate problem for financial markets, however, is that a very large number of bond owners (and a smaller group of stock owners) have no interest in a logical assessment of the situation. All they know is, rates have turned up--and that means it’s time to bail.

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Indeed, what last week’s turmoil in bond and stock markets exposed was the soft underbelly of this bull market: The extreme level of speculation in long-term bonds, and the massive number of inexperienced investors who have shifted from safe bank CDs to higher-risk bonds, utility stocks and other income substitutes over the past two years.

With even a whiff of higher interest rates in the air, the short-term speculators who rode long-term bond yields down for most of 1993 now are anxious to cash in their chips. Hence, over the past three weeks the yield on 30-year T-bonds has surged 0.41 points, to 6.20%; the yield on 10-year T-notes has risen even faster, up 0.56 points to 5.73% now.

Meanwhile, small investors who may have thought they were long-term investors in bonds and utility stocks are suddenly reconsidering, as the rise in interest rates erodes bond mutual fund share prices and sends utility shares plummeting.

Three major mutual fund companies--Fidelity Investments, Vanguard Group and T. Rowe Price--confirmed on Friday that they experienced net outflows of cash from their long-term Treasury and corporate bond funds last week.

The selling by bond fund holders is modest so far, but it adds to the mess in the bond market by either forcing portfolio managers to liquidate bonds, or by limiting their ability to be buyers.

At Valley Forge, Pa.-based Vanguard, investors yanked $60 million from long-term Treasury and corporate bond funds in the first four days of last week, which was equal to the total outflow for all of October, spokesman Brian Mattes said. As recently as September, money was flowing into rather than out of those funds, which hold about $20 billion, Mattes said.

Utility stock funds also have begun to experience outflows, after ballooning in size this year as investors poured in, hungry for high yields.

In Plymouth Meeting, Pa., the utility-heavy Stratton Monthly Dividend stock fund had been taking in about $10 million a month in fresh cash this year, boosting its assets to $180 million as of last month.

But last week, investors pulled $2 million from the Stratton fund, as utility stocks continued to plunge on worries about rising interest rates.

With just 3% of his fund’s assets in cash, manager James Stratton concedes that he has been forced to join the selling of utility stocks, to raise the money needed to meet shareholder redemptions. In fact, he places the blame for the 11% drop in the Dow utility stock average since September largely on the fund industry.

“I think the panic in these stocks has been triggered by the need for liquidity by utility mutual funds,” Stratton says.

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The big question now: Is this a brief bout of selling by a relative handful of small investors in bonds and utility stocks, or the start of an exodus by people who never really belonged in these higher-risk assets to begin with?

Neal Litvack, a Fidelity Investments executive in Boston who closely tracks investor buying and selling patterns, admits that one of the fund industry’s greatest concerns has been the perceived lack of commitment on the part of bond fund owners.

Stock fund owners, after all, at least say they’re long-term investors, and probably believe it in their hearts. But many bond fund owners are simply opportunists. If their share price drops a few percent, or they find a better (of safer) yield somewhere else, they may exit in a flash.

“Bond fund investors haven’t given (their investment) nearly as much thought, or shopped as hard for it, as have stock fund investors,” Litvack says.

Given the sheer volume of bond and utility-stock mutual fund purchases over the past two years, even if just 10% of those buyers decide to leave, it could cause plenty of trouble in the markets near-term.

In other words, even though bond yields shouldn’t rise much more based solely on the economy’s fundamentals, continued heavy selling of bonds by investors who simply want out--at whatever price--could fuel a surprising spike in rates by year’s end.

It wouldn’t last. But with the economy picking up anyway, a sudden spike in bond yields could be enough to change the direction of interest rates for good: Investor interest in bonds would probably dry up, and each additional sign of economic strength would exert a little more upward pressure on rates.

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What about the stock market under that scenario? A temporary shakeout may be unavoidable. But a growing economy means higher corporate profits, which over time will work to take investors’ minds off the fact that interest rates have bottomed.

Fears that even a slight increase in interest rates will destroy stocks--and economic growth--make no sense, economists point out. Short-term rates were as high as 5% two years ago, yet the economy still grew. A rise from 3% now to 3.5% or even 4% would hardly constitute a disaster.

Moreover, the stock market should gain as some of the investors leaving bonds search for higher returns than what money market funds or bank CDs can offer. “I think you’ll see a flow of money from bond funds to stock funds,” says Goldman Sachs’ Einhorn.

Some fund managers are already betting on that. The $1.3-billion St. Louis-based Lindner Dividend Fund announced Friday that it is reopening to new investors. It had been closed since March.

In part, fund manager Eric Ryback may be protecting himself: With just 1% of the portfolio in cash, he could use fresh dollars in case he’s hit by redemption calls from current shareholders.

But Ryback insists, “I’m reopening because I see buying opportunities.” With many bank, utility and other stocks beaten down over the past month, Ryback says he’s eager to grab some bargains.

Rising Rates: Too Much Hysteria?

Stronger economic growth has boosted interest rates in recent weeks, but many experts say Wall Street’s concern about higher rates is overblown: There is little likelihood of a return soon to the rates of 1990 or 1991.

Stocks’ Correction: How Bad So Far? The Standard & Poor’s 500 stock index is off just 2.1% from its peak and could drop further if interest rates jump. But these high-quality issues have already plunged much more steeply.

All stocks trade on NYSE except Intel (Nasdaq).

1993 Fri. Pct. Div. Stock high close drop yld. BankAmerica 55 1/2 41 7/8 -25% 3.3% BancOne 49 1/8 36 7/8 -25% 3.4% SCEcorp. 25 3/4 20 5/8 -20% 6.9% USX-U.S. Steel 46 36 5/8 -20% 2.7% SunAmerica 46 1/2 37 7/8 -19% 0.7% Primerica Corp. 49 1/2 40 5/8 -18% 1.2% Promus Corp. 82 1/2 67 1/4 -18% nil Intel Corp. 74 1/4 60 3/4 -18% 0.3% Chase Manhattan 38 32 3/8 -15% 3.7% Air Products & Chem. 48 1/2 42 1/8 -13% 2.2% Texas Utilities 49 3/4 43 3/4 -12% 7.0% Goodyear Tire 47 43 1/4 -8% 1.4% General Electric 100 7/8 94 1/8 -7% 2.7%