Small Investors Still Flee Bonds, but Should They?

Rarely has a financial market rallied so powerfully . . . and been so ignored, disbelieved and even detested by individual investors.

That has been the story of the bond market thus far in 1995.

As interest rates have plummeted with the weakening economy, long-term U.S. Treasury bonds’ total return so far this year, meaning interest earned plus price appreciation, is a spectacular 15.3%, according to a Merrill Lynch & Co. index.

That more than recoups the 7.5% net loss suffered by those bonds last year, when interest rates spiked upward and eroded the principal value of older fixed-rate bonds.

Yet new purchases of bond mutual funds (before adjusting for redemptions) were $11.4 billion in April, 30% less than the $16.1 billion of April, 1994--a period when rising rates were rapidly devaluing bond fund share prices.

What’s more, while stocks’ bull market advance has been warmly embraced by small investors--they bought stock mutual funds in April at the fastest pace since last August--bond mutual funds have suffered net redemptions in three of the last four months, as sellers have outnumbered new buyers.

Why are individual investors still running from bonds? And more important, is that the intelligent thing to be doing now, with the economy slowing markedly, the national savings rate rising and the Republican Congress staking its political future on the promise of massive federal spending cuts?

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Some Wall Street pros think the “why” is fairly easily answered: Just like many institutional investors, individuals entered 1995 shellshocked by the interest-rate surge engineered last year by the Federal Reserve Board, which produced the biggest bond market losses of the century.

Hence, when rates began to tumble this year, most investors doubted the decline could last. As the slide has steepened, pulling the benchmark 30-year Treasury bond yield down from 8.15% in November to 6.75% now, investors’ disbelief has become disgust, some bond-market veterans say.

“I don’t think people were prepared for the volatility in the bond market,” says Jack Sharry, a managing director at mutual fund giant Putnam Investments in Boston. Embarrassed, confused or frustrated by the market, many people are either still selling out or refusing to buy in, despite the rally’s intensity, he says.

Another negative is that investors who bought bonds or bond funds in 1993 probably still have a principal loss, because yields remain above that year’s lows. While those investors also have been collecting interest all along, psychologically their principal loss, though relatively small, may blind them to the fact that their “total return” is positive.

Lastly, some investors are probably responding to something quite basic: the comparative unattractiveness of today’s lower yields.

Individuals were big buyers of two-year Treasury notes in December, when their annualized yield was 7.57%. At the current yield of 5.99%, it’s not surprising that fewer people are interested.

Instead, many investors who want income are taking the easy and seemingly sensible approach of keeping their money in very short-term accounts, such as money market mutual funds and bank certificates of deposit.

The average money fund yield now is 5.5%, just a half-point less than what a two-year T-note yields. So why, many people figure, take the risk of locking up your cash for two years?

The danger in staying very short-term is that it is an all-or-nothing bet on interest rates’ either staying where they are or rising again. The question that bond-wary investors need to ask, say some experts, is: What happens if rates continue to decline?

Lacy Hunt, chief economist at HSBC Securities in New York, has been arguing for months that the economy was deteriorating more quickly than others believed. He figures the Fed will be forced to reduce short-term rates from the current 6% range to 5% by year’s end, in the process pulling longer-term yields down further.

“I think the long-term [30-year] Treasury bond is going below 6% again,” Hunt says unequivocally.

To be sure, his is an extremely bullish view. Yet the narrow difference between money market yields and longer-term bond yields indicates that the market is already betting on a recession and a cut in short-term rates by the Fed, says Robert Auwaerter, who manages or co-manages several government bond funds at the Vanguard Group in Valley Forge, Pa.

“Our belief is that the economy isn’t as weak as some of the recent numbers have suggested,” Auwaerter says. For that reason, he doesn’t see the merit in buying longer-term bonds at current yields. “You’re not being paid nearly enough to take the risk of going out,” he says.

Ron Rough, director of research at Schabacker Investment Management in Gaithersburg, Md., was wildly bullish about bonds earlier this year--at much higher yields. Now, he’s worried that any fresh signs of economic strength could cause a reversal in bonds, especially with so many trigger-finger players in the market.

“We wouldn’t be surprised to see yields pick back up” somewhat, Rough says.

But even if that happens, simple mathematics dictates that bond owners’ principal wouldn’t be hit as hard as in 1994.

Last year, the yield on five-year Treasury notes, to use one example, rocketed from 5.20% to 7.82%. Today it’s at 6.19%. Even if that yield soars back to 7.82%--a level that assumed a roaring economy--your potential paper principal loss would be less than two-thirds of what was lost in 1994.

Some bond pros suggest that income-oriented investors focus not on the next few months, but the next few years. If inflation can stay under 4%, bond bulls argue that interest rates are more likely to stay in a narrow range or decline further. The bulls’ case is that the Fed accomplished its goals last year--slowing the economy and braking inflation; that bond chapter is history.

“You need to forget where you’ve been and think about where you’re going,” says Ron Speaker, manager of the Janus Flexible Income bond fund in Denver. The next big story in bonds, he contends, could be a “grasp for yield,” as aging baby boomers continue to save more, while Uncle Sam’s voracious pace of borrowing (and bond-issuance) actually cools.

It’s worth noting that U.S. interest rates have been declining in a saw-toothed pattern for the last 14 years, with each periodic spike reaching a lower threshold than the prior one. That decline has occurred mainly because of falling inflation. Many economists have wondered how much lower rates might be if Americans saved more or if the federal government borrowed less.

Stephen Slifer, chief financial economist at Lehman Bros. in New York, says the widespread skepticism about the recently rebounding U.S. savings rate--and about Republicans’ ability to force a balanced federal budget by 2002--isn’t surprising. But that just suggests little of the potential benefit of those powerful forces is yet built into bond yields, he says.

With long-term government bonds yielding 6.75% and corporate bonds paying 7.5% or better, Slifer sees more risk in ignoring those returns than in grabbing them. “I’d be as far out on the yield curve as I could get,” he says.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Interest Rates Drop...

Month-end data, and latest:

May 1995

1 yr T-bill: 5.88%

30 yr T-bond: 6.75%

Total returns, year-to-date, for key bond indexes: Long-term T-bonds: +15.3% Junk bonds: +11.7% Long-term munis: +11.1% GNMA bonds: +10.8%

Net new cash flow into bond mutual funds, monthly, in billions of dollars:

April 1995: -$1.4

Source: Investment Company Institute; Merrill Lynch