After years of flying high, bonds stabilize

STAYING AHEAD

January 16, 1994|By JANE BRYANT QUINN | JANE BRYANT QUINN,Washington Post Writers Group

NEW YORK -- For more than a decade, bond investors have lived a life of superlative reward. When interest rates drop, they raise the value of bonds and bond mutual funds, and since the early '80s, rates have dropped from historic peaks. Year after year, you've been racking up high income from your older bonds; you also earned capital gains, as the market price for bonds went up. In the 12 months ending last November, total returns from U.S. Government fixed-income funds climbed by around 10.5 percent.

Is the ride finally over? If not, the end is pretty near. Bond analyst Ron Daino of Smith Barney Shearson thinks that rates for long-term Treasury bonds will ultimately bottom out at somewhere between 5 percent and 5.5 percent, down from 6.3 percent last week. So at some point (if not this year, then in the future), you might still earn some capital gains on your fund.

But they'll be no big deal, compared with the capital gains of the past.

Perhaps more to the point, will you lose money on your bond or bond fund in 1994?

That depends on how strong the economy is. Interest rates ran up a bit (and bond-fund shares ran down) late in 1993, as business improved and investors started to worry that inflation would tick up and interest rates would rise.

The consensus is that that worry is premature. A majority of economists forecast a moderate slowing in business later this winter; interest rates might drop back or at least stay pretty steady. By contrast, Michael Metz, Oppenheimer's market strategist, thinks that rates will climb to 7 percent or more. If that happens, it would erode your returns.

On the whole, professional investors are taking a cautious stance. Gerard MacDonell, associate editor of the Montreal-based BCA Interest Rate Forecast, believes that the 1994 market for long-term Treasury bonds will be pretty safe but with uninspiring gains. Steve Leuthold of the Leuthold group in Minneapolis foresees minimal returns over the next six to 12 months.

Still, there are three areas of opportunity:

1. Municipal bonds, for investors whose federal tax bracket is 28 percent or higher. Today's tax-adjusted yields are unusually high, relative to yields on taxable Treasury bonds. That's because a record supply of new munis swamped the market last year. Floods of high-rate bonds from the early 1980s were refinanced at much lower rates and demand from buyers failed to keep up, says Robert Dennis, manager of the MFS Municipal Bond Fund.

This year, however, Dennis expects a big drop-off in newly issued bonds.

The major refinancing binge is over, and for two straight years, state and local governments have launched fewer projects that need public funding. Reduced supply should give muni bond performance a boost. In the 28 percent federal bracket, a 5.5 percent muni equals a 7.6 percent taxable return; your return will be higher if you're also saving on state and local income taxes.

2. High-yield (junk) bond mutual funds, which buy bonds from companies with lower credit ratings. For the 12 months ending in November, they posted 19.1 percent in total returns, according to Lipper Analytical Services. Of that gain, an average of 9.3 percent came from interest over the year; the rest came from capital gains, as interest rates fell.

In the view of Steve Leuthold, the risk in high-yield bond funds is small. Even if interest rates rise this year, and bond prices fall, junk bonds pay enough to compensate. What's more, in an improving economy, the credit rating on many companies will rise.

3. World bond funds. Interest rates in continental Europe are expected to drop this year, as the central banks in Germany and France start to push their economies out of recession.

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