The Bond Market MONSTER : Some Demonize It, But It’s a Creature of Our Own Making

“I used to think if there was reincarnation, I wanted to come back as the President, the Pope, or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” -- Presidential adviser James C. Carville, quoted in the book “The Agenda” by Bob Woodward

As the governors of the Federal Reserve Board voted their sixth official interest rate increase of 1994 last Tuesday, picketers from organized labor and consumer groups marched in front of the central bank’s fortress-like Washington headquarters.

“Jobs, Not Rate Hikes,” one placard read. “Greenspan, Have You Ever Been Out of Work?” asked another.

But even within the ranks of Americans who oppose the Fed’s policy of raising interest rates to slow the economy, many believe the protesters’ anger is misdirected.

Don’t blame the Fed, they say. Blame the bond market--that faceless manic multitrillion-dollar monster that swoons at the mere thought of a healthy economy that could bring an uptick in inflation.

“Monetary policy in this country is controlled by bond traders who live in high-rises and are completely out of touch with reality,” argues Jerry Jasinowski, head of the National Assn. of Manufacturers, whose members don’t want to see growth in a chokehold.

By Jasinowski’s reckoning--and that of more than a few other Fed critics--the central bank has felt compelled to punish the economy with ever-higher short-term interest rates this year mostly to appease a seemingly select group of investors who own bonds.

Bond owners, the logic goes, can’t stand the idea of meaningful economic growth because they’re terrified of the possibility of higher inflation, which would erode the value of money they’ve locked up in long-term bonds at fixed rates.

Yet as Jasinowski and others point out, the economy has advanced this year without higher inflation. With 1994 almost over, consumer prices are rising at a lower rate even than in 1993--an annualized 2.6% through October, versus 2.7% last year.

Moreover, many experts argue that with bitterly intense competition in the global economy and labor in excess supply worldwide, inflation simply won’t be a problem in the ‘90s. Someone will always do things cheaper.

The bond market, however, is not impressed. Whereas the Fed controls short-term rates, bond investors determine longer-term rates, which are considered much more important to the economy’s health. And all year long the bond market has pushed long-term yields ever higher. The investors’ message to the Fed, according to those who would demonize the bond market: “Inflation is coming! Inflation is coming! Keep tightening credit and stop the economy!”

Investors today are demanding an annualized yield of 8.12% to take the risk of owning a 30-year U.S. Treasury bond, a benchmark for long-term rates. Just a year ago, 30-year T-bonds were sold at a yield of 5.8%, the lowest in 20 years.

The surge in bond yields to three-year highs has blasted other long-term interest rates worldwide higher as well this year, boosting the cost of mortgages and car loans and the price at which many businesses and governments borrow. Indirectly, the stock market has been affected as well, with bond traders’ counter-intuitive thinking--that good economic news is a bad omen--now holding sway on Wall Street.

But whereas the bond market’s critics paint it as a towering, malicious monster, some analysts see an entity more akin to a pitiful, helpless giant--the uncontrollable creation of a decades-long binge of government, corporate and consumer borrowing.

It is powerful, dangerous and often irrational, but “this is not some private club,” says James Bianco, a bond historian at Arbor Trading Group in Barrington, Ill. “Think of who the bond market is,” he says. “It’s pension funds, 401 (k) (retirement) accounts, mutual funds, governments, corporations, individuals. When you add it all up, we’re all bond holders.”

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What’s more, higher long-term interest rates appear to have had only a minimal effect so far on the broad economy, which continues to expand and create jobs. But the damage to bond holders themselves has been devastating: Every increase in current bond yields devalues older bonds issued in recent years at lower yields.

By Bianco’s calculations, interest rates have risen so rapidly over the past 12 months that bond holders have experienced the most severe devaluation of their securities in this century.

“The greatest number of victims of higher bond yields have been in the bond market itself,” agrees Bruce Steinberg, economist at Merrill Lynch & Co.

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The image of the bond market as a bogyman is a relatively new one.

In the United States and abroad, bond markets for most of the 20th Century were the staid province of high-quality borrowers, such as sovereign states and major corporations, and highly conservative investor/creditors, such as bank trust departments.

With the number of players on both sides relatively limited--as was their ability to trade and track bonds and judge the true extent of inflation--the movement of long-term interest rates occurred at a snail’s pace for decades.

Sidney Homer and Richard Sylla, in their book “A History of Interest Rates,” show that yields on high-quality corporate bonds took 20 years (1900 to 1920) to rise from 3.5% to 5% and another 20 years (1920 to 1940) to decline from 5% to 2.8%.

As recently as the early 1970s, the bond market was a sleepy place essentially run by arch-conservative Eastern investment bankers and their equally conservative bank and life insurance company clients.

William Gross, the 50-year-old managing director of Newport Beach-based Pacific Investment Management Co.’s $55-billion bond portfolio, recalls his first job out of college in 1971 at Pacific Mutual Life in downtown Los Angeles.

“I had to go into the vault and clip the coupons on the bonds stored there,” Gross says. Coupons were interest tickets attached to bonds; they had to be detached and mailed to the bond issuer twice a year to receive interest owed.

“Those bonds weren’t traded,” Gross says. “They just sat there--for five, 10, 15 years or more.”

Like so many other aspects of American life, the bond market began to change radically in the mid-1970s, with the Arab oil embargo and soaring energy prices. The generally slow upward creep of inflation and interest rates began to accelerate. Bond owners, often left behind the curve by accepting yields that inflation quickly eroded, began to assert their power as creditors.

More important, the use of debt began to accelerate as America aged and grew more affluent, the size of federal and local governments ballooned and corporations changed their attitude about borrowing. At the same time, the appetite for bonds surged on the part of institutional investors, who were flush with pension dollars set aside for future retirees.

By 1981, with the annual inflation rate running at 13%, bond investors were demanding the highest interest rates in U.S. history--yields of more than 14% on long-term Treasury bonds, up from 8% just two years earlier.

At that point, the Federal Reserve, under then-Chairman Paul Volcker, committed itself to breaking the inflation cycle by inducing a severe recession with short-term interest rates in excess of 20%.

What’s worth noting is that the bond market wasn’t blamed for that then-unprecedented rate surge. Inflation was real, and the image of the bond investor was that of victim, not perpetrator.

What is so different today, a mere 13 years later, that makes the bond market so hated and feared?

If bigness alone makes something intimidating, the bond market is that in spades. The debt expansion that began in the 1970s has increased exponentially since 1980:

* U.S. government-related debt has exploded from $1 trillion outstanding in 1980 to $5.3 trillion now, the result of years of record federal budget deficits.

* Outstanding U.S. corporate and foreign bonds have more than quadrupled since 1980, from $508 billion to $2.2 trillion, and municipal bonds issued now total almost $1.3 trillion, up from $365 billion.

* All told, the value of bond debt has reached $8.8 trillion, up 370% from 1980. To put that in perspective, consider that the Wilshire market value index of 5,000 U.S. stocks is up only 194% in the same period, to about $4.6 trillion.

Not only do investors own more fixed-rate bond assets than ever before, but technology allows them to buy and sell bonds in the blink of an eye, assuring that yields can react instantly to investors’ perceptions of what is a “fair” return.

But as mammoth as it is, the bond market from 1981 through 1993 did not use its power to extort ever-rising yields from the world’s myriad borrowers. On the contrary, what has been forgotten in the angry rhetoric about interest rates this year is that bond yields have mostly been in decline for the past 13 years.

And contrary to what the market’s detractors allege, many big bond investors say fear of higher inflation in a healthy economy isn’t the overriding issue driving bond yields this year.

Instead, they see in rates’ sudden turnaround the violent backlash to a sea change in the global economy--a backlash worsened by bond investors’ own gluttony in recent years. Investors had willingly snapped up bonds at ever-lower yields, often with funds borrowed at even lower short-term rates. They assumed that economic growth would remain anemic--and, more important, that the Federal Reserve would continue to keep short-term interest rates low.

“Too many investors believed the U.S. and other major economies were locked in a quiet depression,” said John Lonski, economist at Moody’s Investors Service in New York. “That assumption proved to be disastrously wrong for bond holders.”

Now, with the world economy clearly on the upswing again, bond investors have many new considerations in determining a logical “price” for money, said Pacific Investment Management’s Gross.

First and foremost, he notes, as long as demand for credit is rising, its cost can go up--hardly a new concept. And with the global economy now almost entirely capitalist--for the first time since 1917--and recessions in Europe and Japan ending, bond investors have begun to weigh the possibility of a “capital shortage” in the years ahead.

Even with low inflation worldwide, Gross said, the price of credit would conceivably have to rise if there were greater global demand for money than investors had ever witnessed.

Something else also is at work in molding bond market psychology today: the simple desire to get out of the way of bonds’ reversal of fortune and to take advantage of higher yields on much safer short-term bank CDs and money market accounts, courtesy of the Fed’s tighter-credit policy.

Indeed, the sudden lack of demand for bonds, as market yields have risen and investors’ holdings have tumbled in value, has been as significant a force in the market as actual selling.

As have much smaller investors, Gross and his staff of 14 portfolio managers have become both cause and effect in the 1994 bond bear market. They have helped cause it by becoming increasingly leery of aggressively investing their clients’ fresh cash in longer-term bonds as yields have continued to rise. That has forced bond issuers--such as Uncle Sam--to offer higher yields to attract buyers.

At the same time, PIMCO has suffered the effects of rising yields, as its giant portfolio of older government, corporate and other bonds has been devalued. “I’ve lost $5 billion (on paper) as bond prices have gone down this year,” Gross said, not disguising the pain that loss has caused him professionally.

With long-term Treasury bond yields now over 8%, the “real,” after-inflation yield to investors is more than 5%--an extremely attractive return, if not a record high, Gross contends.

But the momentum of markets--bull or bear--has a life of its own, he said. After nine months of extraordinary losses, “investors look at this market and say, ‘I’m not going to invest in it because it only goes down.’ ” Burned badly, the same investors who gorged on bonds in 1993 now shun them.

That may make the bond market an angry, vengeful monster to some. And unquestionably, this monster’s actions have consequences for the economy--on the upside and on the downside.

Worth remembering, though, is that this is a Frankenstein of our own creation--as creditors, as investors, and not least as the most profligate of borrowers.

What’s Fair for Bond Holders?

What are long-term interest rates supposed to be?

That question is key in judging whether bond investors have pushed yields up exorbitantly this year, as some economists contend.

In theory, bond yields should guarantee investors a fair return above the rate of inflation, thereby rewarding them for taking the risk of locking up their funds for a long time.

But what is “fair” for a bond holder? Since 1913, yields on long-term government bonds (that is, 20- to 30-year issues) have averaged 3 percentage points above the inflation rate, according to James Bianco at Arbor Trading Group in Barrington, Ill.

In other words, if inflation was 1%, bond yields averaged 4%. If inflation was 7%, bond yields averaged 10%. The after-inflation yield is called the “real” yield.

For much of the 1945-to-1981 era, however, inflation accelerated faster than interest rates. The result was that bond investors’ real returns were continually eroded by inflation. In fact, bonds are said to have been in a bear market for most of that 36-year period, meaning bond investors generally lost money after inflation.

Mainly for that reason, skittish investors have been much warier about accepting lower real yields on bonds in recent years, even as inflation has declined since 1981. The fear is ever-present that inflation could resurge.

Even so, Bianco notes that with 30-year Treasury bonds yielding 8.12% currently and inflation around 3%, the real yield of 5% or so matches the average real return since 1981--so investors really aren’t demanding much more than they were getting in the ‘80s.

The Mechanics of a Bond

* Why is it that bond owners lose money as market interest rates rise?

Think of a seesaw, with a bond’s price on one end and its yield on the other. The two ends always move in opposite directions.

Take the example of a U.S. Treasury 30-year bond issued in 1993. An investor who bought it new paid $1,000 for a security that will pay 6.25% interest, or $62.50, annually for the next 30 years.

That may have seemed like a decent enough return at the time. But since then, market interest rates have zoomed. Today, investors are demanding a yield of 8.1% on new 30-year T-bonds.

Owners of the older T-bond still are earning 6.25%, and if they hold the bond to maturity they’ll get their full $1,000 back, as well.

But if they try to sell the bond now, buyers naturally will demand that the yield match the market.

To accomplish that, the bond’s price is marked down. Instead of $1,000, the market price of the bond today is about $793, a 21% decline from what the original investors paid.

Divide annual interest earnings of $62.50 by $793 and you get a “current” yield of about 7.9% for a new buyer. And by factoring in the added return expected by reinvesting the bond’s annual interest earnings, the true yield--called “yield to maturity”--works out to about 8.1%, thereby matching the market.

What happens if market yields begin to decline again? As the seesaw analogy implies, the bond’s price will rise accordingly.

Price: $1,000 Yield: 6.25%

Price: $782 Yield: 8.1%

An Explosion of Debt

The bond market’s power to drive Wall Street, mold federal policy and shape the economy has mushroomed over the last 14 years, as bond debt has rocketed worldwide. How key categories of bond debt have grown:

Bonds outstanding, in billions of dollars:

Category / Debt outstanding:

U.S. govt.-related:

1980: $1,016

1994: $5,340

Corporate and foreign:

1980: $508

1994: $2,228

Municipal:

1980: $365

1994: $1,270

How Interest Rates Have Turned

Bond yields have jumped this year as the Federal Reserve Board has tightened credit adn the economy has surged, fueling inflation worries. While yields are still far below historical peaks, the magnitude of the rise in rates over the past year has been more dramatic than at any time sine the 1920s.

30-year U.S. Treasury bond, average yield each year (except latest):

1977: 7.9%

1981: 13.5%

1994: 8.1%

Source: Bloomberg Business News

Worst Bear Markets

Because a bond pays a fixed yield, rising yields on newly issued bonds automatically devalue older bonds, pushing their prices down. Over the past year, prices have fallen so far that bondholders’ total return--interest payments less price decline--has been negative.

12 months ended / Long-term T-Bond total return:

Oct. 1994: -17.5%

March, 1980: -17.1%

Sept., 1969: -12.5%

June, 1981: -12.3%

April, 1959: -9.8%

Source: Arbor Trading Group