Bonds can be rewarding investment, but they're no place for novices

January 06, 1991|By Philip Moeller

Despite its undeserved image of serving coupon-clipping matrons, the bond market has a sensitivity to interest-rate swings and corporate takeovers that can make for harrowing if exhilarating times.

This sensitivity makes bonds swing even more quickly on occasion than stocks, and, while the price movements may appear small, such ticks are often magnified a thousandfold because of the huge volumes in which bonds are traded at the institutional level. Add in the continued deterioration of the "junk" bond market in 1990 and the debate over government interest-rate policies and you have the ingredients for a tough way to make a living.

Still, for investors with firm resolves and long-term horizons, bonds can be a rewarding investment. A gradual decline in interest rates that begin in 1989 continued last year, although it was rudely interrupted during the fall, after Saddam Hussein's invasion of Kuwait led to higher oil prices and interest rates rose because of concerns about higher rates of inflation.

Later in the year, however, rates resumed their decline, especially when the Federal Reserve Board lowered some important interest rates that it directly controls.

Declining interest rates are good news for owners of existing bonds, and most forecasters expect bonds to continue producing returns to investors in 1991 that are better than

those for stocks.

To understand why, one needs to know how the bond market works. So here, for those readers who are unfamiliar with bonds, is my bond primer; those familiar with that market may feel free to skip it.

A bond is an IOU from the issuer to the bearer, promising to repay the face amount or principal value of the bond at the date it matures. Until then, the issuer promises to pay interest to the bondholder at the rate stated in the bond.

This is usually a fixed percentage of the principal amount of the bond. Let's take the case of a bond with a principal value of $1,000 and an interest rate of 10 percent. At that rate, the interest payment (simplified for this example) would be $100 a year. And, if the prevailing level of long-term interest rates in the market place was 10 percent, the bond would probably have a resale value of $1,000 in the marketplace.

If interest rates rose to 12.5 percent, however, no one would want to buy a bond yielding only 10 percent. So the resale value of our bond would fall until its yield -- the bond's interest payment divided by its resale price -- was 12.5 percent. We already know the interest payment is $100 and will remain at $100 because it's a fixed percentage of the principal or face value of the bond.

With this in mind, it's just a matter of solving the equation. In this case, a resale price of $800 produces a yield of 12.5 percent, because 100 divided by 800 equals one-eighth or 12.5 percent.

Bond prices thus are inversely related to interest rates. Higher interest rates drive down prices of existing bonds; lower rates cause bond prices to rise.

Being close to a turning point for rates creates a great temptation to lock in high yields and seek appreciation in bond prices as rates decline. That's been the general advice given here the past two years, and it's proved generally correct.

As with stocks, the underlying performance of the bond issuer is of primary concern. Most large companies prefer a capital structure that blends bonds (debt) and stocks (equity). This gives them access to both sources of financing and allows them to use the most attractive option when they need to raise new funds.

Stocks may appear to be a cheaper source of new money to a company than bonds, because the out-of-pocket costs to companies (stock dividends) is smaller than the interest charges carried by bonds. However, tax laws make corporate debt cheaper to sell than equity because interest payments are tax-deductible and stock dividends are paid out of post-tax profits.

The craze in junk bonds has made the market even more turbulent. These bonds are riskier securities than the corporate bonds that receive high marks from the rating agencies. (Standard & Poor's and Moody's are the two major rating houses.)

Junk bonds offer correspondingly higher returns for their higher risk levels. Until last year, there had been few problems with junk debt. However, concern over their heavy use in leveraged buyouts appeared to have been well placed. Many of the companies that sold junk bonds simply couldn't carry such huge debt loads, and when the economy weakened, they couldn't generate enough cash flow to maintain their debt repayments. Most experts feel junk-debt problems will be with us for years.

So, too, will be the guessing game over the direction of interest rates. Right now, there's an unusually strong consensus among economists for still lower interest rates, courtesy of the recession.

The Fed, however, is expected to move quickly to raise rates if a recovering economy seems likely to produce higher rates of inflation.

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