A Blue Moon For Bonds

After 15 years of negotiating the rocky terrain of the bond market, Philip Barach has seen wild extremes: a 20% prime rate in the early 1980s, a 14% Treasury bond mid-decade, and, recently, the lowest short-term interest rates in nearly 30 years. But most astounding to Barach and thousands of other bond-market pros is the gigantic spread currently between the three-month U.S. Treasury bill, now 3.30%, and the 30-year Treasury bond, 7.61%.

Indeed, the range of interest rates on bonds of varying maturities--when plotted on a graph, it's called the "yield curve"--is at a historic high. There are 431 "basis points" (each is of 1%) between the three-month and 30-year government securities (chart). That may not sound like much, but in the bond market, it's light-years.

As with most aberrations in the financial markets, the steep curve offers both big risks and big rewards. Many bond players--including Barach, who counts the Enterprise Government Securities Fund among the $5 billion he manages for Trust Co. of the West--avoid the extremes and focus on the middle, in the two-to-five-year range. At that point, he says, "investors are getting paid an awful lot to take on a little more risk."

`SWEET SPOTS.' Of course, most of the time, long-term rates are higher than short, and for good reason. Investors who buy long-term bonds demand a higher interest rate to compensate them for the risks of waiting decades to get their principal back. Shorter securities yield less since the principal is repaid sooner. But the difference between long and short is typically less than 200 basis points. The average curve of the last 10 years, says Francis H. Trainer Jr., head of fixed-income investing at Sanford C. Bernstein & Co., spans only 172 basis points. If today's curve were "normal," he adds, the three-month Treasury bill would yield about 5%, and the 30-year just 6.7%.

Two years ago, with the economy slipping into recession, the difference between short and long rates was only 40 basis points, a virtually flat curve. But then the Federal Reserve began a massive effort to stimulate the flagging economy by using its power to force short-term rates down. Yet the Fed has little control over long rates, which have come down only grudgingly. The reason is that bond investors are wary of the ballooning federal deficit, of a potential revival of inflation, and hence of a rebound in interest rates. A one-percentage-point climb in rates would clip 12% off the value of a 30-year bond. With such fears, "long-bond investors are on strike," says Hugh R. Lamle, head of fixed-income and quantitative analysis at M. D. Sass Investors Services.

True, the precipitous drop in short rates is a blow to risk-averse investors who normally prefer the security of money-market funds and certificates of deposit. But the steepness of the yield curve affords risk-shy investors opportunities, too. The trick is to find "sweet spots" on the slope that will let them get additional yield without a commensurate dose of principal risk, should interest rates nudge back up. Says Ron Ryan of Ryan Labs, a bond-research firm: "Like a good skier, you go to where the shape of the slope is best."

GOING LONG. Ryan, for one, finds opportunities in the two-to-three-year range. In moving from three-month bills to three-year notes, he says, the yield rises from 3.30% to 4.89%, almost a 50% pickup in income with a small increase in principal risk if interest rates go back up. Other managers advise investors to move out to five-year bonds, at 5.90%, where they can get yet another 1% in yield. Under a more typical yield curve, the difference between three- and five-year yields would be less than 30 basis points. Seven-year notes are attractive, too, for investors who can take a little more risk. With a 6.41% yield, they offer 84% of the income of a 30-year bond but only half the market risk.

Lamle says tax-paying investors could choose AAA municipal bonds with three-to-seven-year maturities. They now yield about 83% to 85% of what taxables pay. For those in a 31% tax bracket, a five-year muni at 4.9% equals a 7.2% taxable bond. Lamle thinks investors will pick up some price appreciation if munis rally to catch up with Treasuries.

Taxable or tax-free, Bernstein's Trainer says investors should buy securities slightly longer in duration than what they normally choose. Long rates, he predicts, will eventually follow the shorter ones down. "The yield curve is stretched thin like a rubber band, and you can't keep stretching it forever," he says. But might long rates pull short ones back up? Not likely. The Fed controls short rates, and, for now, it wants those rates to stay down.

Of course, there's no guarantee that all will turn out the Fed's way. But few investors want to bet against the powerful central bank. Sure, it's chancy leaving the money funds and CDs, but those who preserved principal by following that course have seen their interest income dwindle. Now, the yield curve's unusual behavior is offering them a chance to enhance their income significantly--with a little more risk.