Interest rate phobia has bond investors on edge

May 09, 1993|By Tom Petruno | Tom Petruno,Los Angeles Times

Nobody can predict interest rates with any consistency. But today, everybody seems to be trying. And for no one are the stakes higher than the uncounted millions of investors who own bonds or bond mutual funds.

If interest rates rise from here, or inflation steams up, bond investors know one thing: They lose. Because a bond's return is locked in for its life, that bond becomes less valuable if new bonds pay more. It also would be eroded by higher inflation.

The seesaw mechanics of the bond market are as old as bonds themselves, but none of this became a national obsession until the 1980s. That was when individual investors began moving into Treasury, corporate and municipal bonds in a big way to grab the unprecedented double-digit yields of that era.

Over the last three years, as the weak economy has allowed short-term interest rates to fall to 30-year lows, the hunt for yield has marched a new army of individual investors out of 3 percent bank certificates of deposit and into 6 percent to 8 percent bonds.

Now, perhaps millions of trigger fingers are waiting for a sign that the economy is ready to boom. Or that inflation is creeping back. Or that President Clinton won't rein in the federal budget deficit.

Any of those signals could mean the long-dreaded turn in interest rates -- a rise in rates that could send bond investors fleeing back into money market funds and other safe havens.

Is it time to anticipate that reversal of fortune and sell bonds?

There's a good argument that the bond party fueled by 12 years of (mostly) falling interest rates can't go on much longer. Since 1989, bond returns have been nearly as good or better than return on stocks, depending on the type of bond.

In theory, that shouldn't happen for any sustained period. The higher-risk investment -- stocks -- should triumph in the long run.

Neil Dabney -- whose Beverly Hills, Calif., firm, Dabney/Resnick Asset Management, is a major player in the high-yield "junk" corporate bond market -- cautions that even that red-hot market has seen its best days for awhile. At most, the top tier of junk issues may produce overall returns of 10 percent to 12 percent a year, he says.

As for the rest of the bond market, including Treasury issues, Mr. Dabney says: "When interest rates were high in the '80s, I felt compelled to buy long-term bonds. I'm not buying them now."

Yet many Wall Street pros find predictions of an imminent sharp rise in interest rates hard to support.

"I still believe we are in a period of very slow economic improvement," says Stephen Lieber, manager of the $112 million Evergreen Foundation stock-and-bond mutual fund in Purchase, N.Y.

Jack Bogle, head of the giant Vanguard Group of mutual funds in Valley Forge, Pa., cautions investors against becoming too focused on how far bond yields have dropped since the early '80s -- and the odds of a return to those old highs.

What's important going forward is simply whether the yields offered on bonds today are attractive relative to inflation and the alternatives, Mr. Bogle says.

For most bond investors, the basic question is this: Do you live on your investment income? If so, you probably have little choice but to stay in bonds until short-term interest rates move significantly higher.

But there's also a second question all bond investors must ask: How much of your principal can you stand to lose, even if just on paper? If you own a 10-year bond that yields 5.9 percent annually, and if similar new bonds pay just a half-percentage point more a year from now, your bond's paper value would be 3.7 percent less.

Subtract 3.7 from 5.9, and your "total return" over that 12-month period would be a mere 2.2 percent. Those are the kinds of numbers that frighten so many bond investors.

You can, however, improve your odds of success in the bond market -- even under such circumstances.

The key is diversification -- not just owning a bond mutual fund instead of a single bond, but owning different types of bonds, some shorter term and some longer.

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