Improving Economy Increases Specter of Rising Interest Rates

The recent spate of positive economic news is making it more likely that long-term interest rates will creep up this year--and that bond investors will have a tough time matching the stellar returns they enjoyed the last two years.

The yield on the benchmark 10-year Treasury note, which dipped to 4.83% last week, had risen to 5% by Tuesday--about the middle of the fairly narrow range in which it has traded since early December.

Mortgage rates have edged up as well, although at an average of just less than 7% they still are below where they started the year.

The important question for investors who stormed into bond mutual funds over the last two years, as well as for home buyers, is whether a “spring surprise” of sharply higher rates could be in store.

That would make homes less affordable and hammer bond investors, who see the value of their investments decline when interest rates rise.

So far, most experts are betting against that scenario, saying that with consumers maxed out and business capital-spending budgets still depressed, the economic expansion will be slow and inflation tame.

“The recovery is real, but it’s a feeble one,” said Bill Gross, chief strategist for Pimco, a fixed-income manager in Newport Beach, whose bond fund assets have swollen from $185 billion at the end of 1999 to $251 billion currently.

Gross is betting that quiescent inflation will keep the Fed from raising short-term rates for the next six to 12 months. That should mean modest profits for bond investors--although probably nothing like the recent run that saw them handily beat stock investors two years in a row.

In 2000, the average government bond mutual fund had a total return--interest plus price appreciation--of 10.4%, contrasted with a 9.1% loss for the benchmark Standard & Poor’s 500 stock index. Last year, the average government bond fund returned 6.7%, contrasted with an 11.8% loss for the S&P; 500.

Returns like that on bonds “are generally not what to expect” this year, said Mario DeRose, a fixed-income strategist at Edward Jones brokerage in St. Louis. Although the market isn’t likely to experience a bust like the one that occurred when rates soared in 1994, the recent boom clearly is over, he said.

“We’ll eventually see losses in bond portfolios--maybe not this year, but it will happen. Investors should be wary and diversify,” DeRose said. He said he’s already seeing signs that investors are selling shorter-term Treasuries and investing the proceeds in the rebounding stock market.

In the inverted logic of fixed-income securities, economic strengthening can be bad news for bonds because it can spark inflation and sway the Fed to raise short-term interest rates.

And the economic news in recent weeks has been surprisingly good. Investors were especially encouraged last week when the Institute for Supply Management reported increased manufacturing in February--the first rise in 19 months. The institute said Tuesday that activity in the service sector, which accounts for four-fifths of the U.S. economy, surged to its highest level since November 2000.

Indeed, Treasury Secretary Paul O’Neill said Tuesday that “our economy maybe never suffered a recession.” The National Bureau of Economic Research--generally accepted as the arbiter in such matters--had decreed that the economy’s record 10-year expansion ended last March.

Despite the positive news, most bond watchers for now agree with Gross that this expansion will be slow at least until late in the year. If that’s the case, a 10-year Treasury note yield of about 5% and 30-year fixed-mortgage rates in the 7% range make sense, said Keith Gumbinger, a vice president at HSH Associates in Butler, N.J., a data firm that surveys lenders.

Rates could quickly shoot higher if Friday’s unemployment report proves more robust than expected. But Gumbinger said most in the mortgage business expect a slowly accelerating economy to push rates up by just a quarter-percentage-point or so this spring.

A Freddie Mac rate survey put the national average at 6.8% for a 30-year fixed-rate mortgage as of Friday. Gumbinger’s survey showed an average of 6.91% for conventional fixed 30-year home loans.

The low rates and rising home prices across most of the nation have been a major reason that--despite record consumer debt loads and bankruptcies--consumer spending has held up well through stock market declines and economic adversity.

As mortgage rates fell to the 6.6% range at year-end, “consumers were able to extract huge savings,” said Tom Atteberry, a Los Angeles-based bond analyst and co-manager of FPA New Income Fund.

“You could significantly lower your mortgage payment or pull money out of your home equity and use it to pay off higher-interest debts--or spend it,” Atteberry said. “Consumer balance sheets were improved.”

On the other hand, as Fed Chairman Alan Greenspan told Congress last week, consumers’ unabated spending makes it unreasonable to expect them to lead the economic recovery. Greenspan said business must lead the way.

Although lower interest rates allowed many businesses to strengthen their balance sheets by issuing long-term bonds cheaply last year, companies also retrenched by drastically drawing down their inventories, as the less-than-full shelves at many retailers at Christmas demonstrated.

Atteberry thinks the recent uptick in business activity reflects rebuilding of those inventories. Without a pickup in consumer spending, however, that buildup could drop off sharply this year, leaving the economy growing sluggishly into 2003, he said.

But Atteberry worries that investors could get squeezed if bond yields jump unexpectedly.

His recommendation: Buy mortgage-backed securities, which generally pay higher yields than Treasuries with almost as much safety, and high-yield corporate bonds, which should benefit as the economy improves and are currently are paying about 6 to 8 percentage points more than Treasury securities.

Gross also expects companies to expand slowly, noting that there’s little sign that businesses are preparing to make the major investments in new markets, acquisitions and equipment that would signal an impending boom.

“During a reality check, you will see that we have [business capital spending] that’s still anemic, a consumer that is basically tapped out in terms of savings and an unemployment rate that continues to climb,” Gross said. “That doesn’t leave a lot of room for growth.”