Buyers Scarfing Up Bonds Despite Bad Case of the Jitters
Last year’s most anguished investor cry was “I can’t believe I didn’t sell my bonds!”
Unfortunately, many of those who finally did sell now are crying again.
The 1994 bear market in U.S. bonds, the worst in this century, has been followed this year by a rally that has astounded most pros with its durability.
Except for the shortest-term securities, bond yields have been in a steep downtrend since late-December. That continued last week, with yields closing Friday at or near seven-month lows.
The five-year U.S. Treasury note yield, for example, which soared from about 5% early in 1994 to 7.82% by year’s end, has slumped to 6.96% now, down nearly a full percentage point.
To put that turnaround in real-money terms, consider: An investor in the typical bond mutual fund has earned 4.1% so far this year in “total return,” which is interest earnings plus the appreciation in bond prices as yields have fallen, according to fund-tracker Lipper Analytical Services.
That more than covers the 3.3% loss suffered by the average bond fund last year, Lipper notes.
Most investors know why yields have dropped: The economy is believed to be slowing, which has seemingly eliminated any need for the Federal Reserve Board to push up short-term interest rates again. Plus, a slower economy would in theory reduce the risk of higher inflation, which is Public Enemy No. 1 for bonds.
Bonds’ performance has been so hot, however, that it’s scaring many Wall Streeters. Some now are calling this rally just an inevitable “technical” bounce after a bear market, an unsustainable rebound.
Others say this is as good as it gets--that interest rates can’t go much lower unless the apparently slowing U.S. economy is about to come to a full stop.
But a few bulls say the party is far from over, simply because so many disbelievers have yet to show up for it.
Some of the most bearish bond market observers are the technicians, notes Ron Juster, government bond trader at Lehman Bros. in New York.
The slide in yields now has retraced about a third of their 1994 rise, a classic rebound after a bear market, but a point at which the market would be expected to stall out or pull back--at least according to chart-watchers, Juster says.
In addition to the worrisome technical signs, he says, bonds’ rally has in recent weeks pulled in many previously cautious portfolio managers, thereby reducing the buying power left in the market.
The Bond Fund Report newsletter in Ashland, Mass., says the “cash” holdings of the average taxable bond fund total 6.8% of assets now, a figure that is up from the start of the year but which has been dropping for three straight weeks. A fund’s cash is money available to buy more bonds. So the lower the cash figure goes, the greater the risk that the bonds’ rally is nearing its end.
Wall Street “is getting long in bonds,” Juster warns. “Better watch out.”
One particular fear is that the most recent bond buyers, nervous that they’re joining the rally too late, will have trigger fingers and will sell out at the first sign that yields might be ready to turn up again. That could exacerbate any sudden market slump.
Some bond traders say investors’ rising apprehension is palpable.
“There isn’t a lot of conviction in this market,” says Peter Auzers, municipal bond trader for Fidelity Investments in Los Angeles.
When the market stumbled early in March--on worries about the plunging dollar--many institutional investors immediately ran to traders with “bid” lists, trying to gauge how much interest the traders might have in buying bonds from fund portfolios, Auzers says.
“On any kind of weakness in the market, a lot of bonds come out for bid. People run for the door,” Auzers says.
Even so, that nervousness has failed to stop the bond market’s rally for more than a few days so far this year. Either the potential sellers have quickly pulled back whatever they thought they might want to sell, or new buyers have surfaced to take bonds away.
Yet from a fundamental point of view, many portfolio managers say they believe yields already fully reflect the economy’s slowdown.
“We’re kind of scratching our heads, asking how it can get any better,” says Randy Merk, fund manager at the Benham Group of mutual funds.
Assuming the Federal Reserve Board holds short-term rates at the current 6%, Merk and other pros say the 6.7% yield on a two-year Treasury note is as low as it should possibly go. Only a Fed cut in short-term rates--something Wall Street generally thinks isn’t possible before year’s end, at the earliest--could justify lower longer-term yields, most pros say.
So if the economy is indeed headed for a “soft landing,” the best that bond owners can expect at these yields is that they’ll earn that interest, but without the chance of a capital gain in the near term, Merk and others say.
Of course, that may be fine with many buy-and-hold investors in individual bonds or bond funds. High-quality corporate and GNMA bonds still are yielding between 7% and 8%, depending on the term. “Junk” corporate yields still are 10% or higher in many cases.
But the risk is that if the economy begins to strengthen, and the market senses that the Fed could be forced into raising short-term rates again, bond yields would almost certainly have to shoot higher as well--because there isn’t enough slack between short and long rates, many experts say.
Yet that kind of hand-wringing is what Joseph Deane, muni bond fund manager at Smith Barney in New York, likes to see. He still thinks there’s plenty of room for yields to fall.
The 30-year T-bond yield, now 7.37%, can go to 6.8% this year, Deane says. The economy is slowing and there are plenty of buyers left to jump into bonds, he argues. Especially in the muni market, where yields have already fallen sharply, Deane says buyers are chasing a shrinking supply of new bonds--a bullish recipe, he says.
“People have been such nonbelievers--that’s what has kept this rally going,” he says. “The thing that will end it is when everybody is optimistic.” But he believes that point is a long way off.
