Individual Investors Are Fleeing Bonds, but Should They?
Rarely has a market rallied so powerfully . . . and been so ignored, disbelieved and 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 this year, meaning interest earned plus price appreciation, is a spectacular 15.3%, according to a Merrill Lynch index.
That more than recoups the 7.5% net loss suffered by those bonds in ‘94, when interest rates spiked up 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 has been warmly embraced by small investors--they bought stock funds in April at the fastest pace since August--bond funds have suffered net redemptions in three of the last four months.
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 promising massive federal spending cuts?
Some experts think the “why” is 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 losses of the century.
Hence, when rates began to tumble this year, most investors doubted it could last. As the slide has steepened, pulling the 30-year T-bond yield down from 8.15% in November to 6.75% now, investors’ disbelief has become disgust, some bond veterans say.
“I don’t think people were prepared for the volatility in the bond market,” says Jack Sharry, managing director at 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 big rally, 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 seemingly sensible approach of keeping their money in short-term accounts, such as money market mutual funds and bank CDs. The average money fund yield now is 5.5%, just a half-point less than the two-year T-note yield. 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, economist at HSBC Securities in New York, has argued for months that the economy was withering. He figures the Fed will be forced to reduce short-term rates from the current 6% range to 5% by 1996, 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, that’s a very bullish view. “Our belief is that the economy isn’t as weak as the recent numbers” suggest, says Robert Auwaerter, manager of several government bond funds at Vanguard Group in Valley Forge, Pa.
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, research chief at Schabacker Investment Management in Gaithersburg, Md., worries that any revival in the economy could cause a reversal in bonds. “We wouldn’t be surprised to see yields pick back up” a bit, he says.
But 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 likely to stay in a narrow range or decline. The bulls’ case is that the Fed met its goals in ‘94--braking the economy and 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 fund in Denver. The next big story in bonds, he contends, could be a “grasp for yield,” as aging baby boomers save more while Uncle Sam borrows less.
It’s worth noting that interest rates have been declining in a saw-toothed pattern for 14 years. That has occurred mainly because of falling inflation. Economists have wondered how much lower rates might be if Americans saved more or if the government ate less.
Stephen Slifer, economist at Lehman Bros. in New York, says the widespread skepticism about the rebounding U.S. savings rate--and about Republicans’ ability to force a balanced federal budget--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% or better, “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
