That other bull market may join Dow

October 02, 2002|By JAY HANCOCK

THE BULL market has powered forward for two decades, confounding experts and enriching millions.

Analysts talk about a new economic era and additional gains to come, and with each new high, it seems, more mutual funds are introduced to catch the cash sluicing into the market. Bears surrender, don longhorns and join the roundup.

Sometimes, cautious voices interrupt the revel. But events seem to prove them wrong. These doubters have been skeptical for years, even as the indexes kept attaining new highs. Why listen now?

I'm talking, of course, about the bond market, whose continuing tear rivals the late bull stock market in longevity, altitude and Holy Toledo factor. The Lehman Brothers U.S. Aggregate Bond Index in 2002 looks a little like the Dow Jones industrial average in 1998 or 1999.

Now that we have relearned the laws of financial gravity, the painfully obvious question is: Will bonds follow the Dow into the landfill?

There are reasons to worry. Bonds are benefiting from the same kinds of economic extremes that pumped and then popped stocks - as well as from the bum stock market itself.

When these forces - inflation, capital investment, stock performance - revert to the mean, bonds will not thrive. But it is far from clear that the economy has finished submitting entries to Guinness or that the run-up in bonds is over.

Bonds are tradable, long-term debt, and their prices are closely tied to interest rates. When rates fall, the prices of previously issued bonds rise. This basically describes the U.S. scene since 1982.

That year, International Business Machines borrowed $100 million by issuing five-year bonds paying 13.875 percent. But less than three years later, overall rates had declined, and IBM sold a new, $300 million batch of bonds paying only 9.625 percent.

Of course, the 1982 bonds, the ones with the higher coupon, had appreciated in value because they paid interest at more than prevailing rates. So went the bond market, for 20 years.

To get an idea of how far interest rates have fallen and bond prices have risen, consider that in 1982 the prime rate was 16.5 percent, short-term certificates of deposit paid 15 percent and 30-year mortgages were 17 percent. Now the prime rate is 4.75 percent, CDs pay 1.5 percent and mortgage rates are less than 6 percent.

The reason for the drop, naturally, is the death of inflation. Rising prices erode the value of fixed-rate securities, so when inflation rages, lenders demand higher interest rates. When inflation dies down, as it has done increasingly since 1982, rates drop, too. And bondholders get handsomely rewarded.

Say that in 1985 you bought a new, 30-year Treasury bond with an interest coupon of 9.875 percent for $1,000. Your bond, with 13 years left until it expires, is worth $1,560 if you sold it today. And it has already paid out $1,480 in interest.

That's an extreme example - a bond with a high interest rate and a long life span - but bonds in general have done very, very well since the early 1980s. According to Baltimore investment house T. Rowe Price Associates, from Dec. 31, 1981, through September 2002, bonds produced an average annual total return of 10.64 percent.

That outgunned the Nasdaq stock index, which returned 9 percent over the same period, says Price. It trailed the 12.4 percent returned by the S&P 500 stock index, but the S&P 500 result, as we have seen, came with much more volatility.

The possible bond bubble has produced the same staunch optimism among some believers and consternation and crow-eating from skeptics that we saw with stocks in the 1990s. More than $100 billion has flowed into bond mutual funds since the beginning of the year, says the Investment Company Institute.

Last December, famous PIMCO Funds bond manager Bill Gross wrote, "The bond bull market is dead!" Now he has changed his view, saying a few weeks ago that the economy's "reflationary aspects" - the rebirth of inflation and higher interest rates - are further off than he thought.

Are they? Bond fans note the sluggish economy, the swooning stock market and worldwide price competition to argue that inflation is a no-show and bonds are a buy, or at least a hold. They expect the Fed to cut short-term rates again. And they point to Japan, where government bonds yield interest of 1 percent, as evidence that U.S. rates have room to move down.

But here's the other view: By any measure, the U.S. money supply is brimming, which could portend inflation. Unlike stocks, bonds can't rise forever because rates can't go below zero, and they're already close. And if the economy gets much worse, many more companies will default on bonds.

At some point, the economy, and possibly inflation, will perk up. If you buy bonds, stick with short maturities, whose prices are affected less by rate swings. Consider inflation-protected Treasury bonds. And, with the Dow in mind, recall the cliche about frying pans and fires.

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