`The Big Money Has Already Been Made'Phillip L. Zweig
Maybe 1993 will turn out to be the year in which a roomful of economists strung end-to-end did actually reach a conclusion.
Almost to a man and woman, they agree that the U.S. economy in 1994 will chug along at a moderate, steady pace, with little risk of a sharp rise in inflation or long-term interest rates. They expect weaker oil prices and the Clinton Administration's tax hike to help keep inflation in check. And while they acknowledge that there's always the chance that something might appear from left field to wreak havoc with their forecasts, they don't think that's very likely.
Under this scenario, short-term interest rates should move up by about 50 basis points in the first half of the year, while the benchmark 30-year Treasury bond should trade between 6% and 6 1/4%, though it could scrape bottom at 5 1/2%. "1994 looks like it's going to be a good year," says Edward J. Campbell, chief economist at Brown Brothers Harriman & Co.
But since good news for the economy is not usually good news for the bond market, what does this mean for fixed-income investors?
For one thing, investors who've gotten hooked on intoxicating double-digit returns over the past several years could be in for a rude awakening. In the domestic bond market, investors will generally have to satisfy themselves with single-digit returns from interest income rather than the hefty capital gains generated by plunging interest rates. "The big money has already been made in bonds," says Campbell. "It's become more of a traders' market." Adds Barbara Kenworthy, portfolio manager at the Dreyfus Corp.: "Two years ago, interest rates were so high it didn't matter where you were. Selection didn't make a lot of difference." Now, she says, "the chances for an easy home run are over. You have to do your homework" and be prepared for surprises. Next year, she adds, the market sectors hitting "home runs" will change frequently: "one month, long Treasuries...the next month, junk, the next month, emerging markets."
For investors still yearning for returns driven by the capital gains of yesteryear, money managers offer this terse piece of advice: Think global, junk, and munis--probably in that order.
"The real story for fixed income is the non-U.S. market," says Thomas J. Steffanci, director of fixed income at Fidelity Investments. He believes that individual investors now ought to have between 10% and 15% of their total portfolio in global fixed-income instruments. "The European, Asian, and emerging markets are the most attractive areas," he says. There are several reasons for this. With Japan and Germany mired in recession, economists believe that interest rates in those and other developed countries still have more room to drop.
FOREIGN ADVENTURE. Stephen Axilrod, vice-chairman of Nikko Securities Co. International and a former Federal Reserve Board official, says that the prospects are "very good" for the "Europeans to ease short rates, because their economies are so weak." Ditto for the Japanese: Even though Japan has already lowered short-term rates dramatically and its Fed funds-rate equivalent is now 2.5%, Axilrod says it "ought to go down another point."
Steffanci says that the bond markets in France, Germany, Denmark, Malaysia, Thailand, and Indonesia "are likely to hold the most promise." He and others are also bullish on the prospects for the Latin American fixed-income market--notably in Mexico and Argentina--but for different reasons. There, he says, the capital gains will occur when--not if--the rating agencies upgrade the sovereign debt of those countries to investment-grade status. Yields on these issues, currently hovering about 225 to 250 basis points over U.S. Treasuries, are out of line with the real risk of default. When the upgrades occur, Steffanci says, they will unleash a massive inflow of money from pension and other funds now barred from investing in junk-grade debt.
"You're going to hear a big sucking sound" of money flowing into these securities, he says. Of the Latin nations, only Colombia and Chile are now rated investment-grade. Though Steffanci doesn't see further 30% to 40% returns in emerging-market bonds or the 15% to 20% returns in developed-world debt posted in the past year or so, he feels emerging-market bond buyers could get returns of half recent levels. Investors could earn returns in the low double digits on developed-country instruments, he thinks. The Latin fixed-income market will be volatile, adds Dreyfus' Kenworthy, but "the Latin names will be some of the stellar performers."
Although such countries as Mexico and Argentina are beginning to issue dollar-denominated "Yankee bonds" that, in theory, Mom and Pop can buy, money managers generally advise individuals seeking to participate in the global fixed-income market to buy funds, rather than single issues. Buying and selling odd lots is typically expensive and inconvenient. Moreover, U.S. individual investors are often the last to hear bad news that would hurt the prices of, say, Latin issues. And bonds are more vulnerable than a bond fund to currency exposure.
JUNK FUNK. In the domestic market, many portfolio managers expect the junk and municipal sectors to turn in the strongest performance next year. "We see more cases of improving credits than declining ones," says A. Keith Brodkin, chairman of Massachusetts Financial Services, a mutual-fund manager. And Fidelity's Steffanci says that the 450 to 500 basis-point spread between junk and Treasury issues reflects a higher historical default rate than is likely to occur in 1994. Steffanci, for one, expects these spreads to narrow next year. In contrast, he says, investors can expect "very little" in capital gains from investment-grade corporate issues, though there are some managers who say that issues in the low-investment-grade region represent good values.
Dreyfus Corp.'s Kenworthy is less enthusiastic about the junk market. Although she says that there are still home runs to be scored on individual issues, she is reluctant to recommend them to small investors. As for junk funds, she says that many money managers, in an attempt to deliver on promised high yields, sometimes invest in second or third choices. Dreyfus, she points out, doesn't offer a junk fund.
BIG PLUNGE. Some fixed-income specialists say municipals could be star performers in 1994, as they have been this year. For one thing, the maximum federal tax rate has been hiked to 39.6%. Pressure on local governments for spending cuts may mean an excess of demand over supply.
Because interest rates have been so low for so long, money managers think home-mortgage refinancing will slow down next year from its record 1993 pace. That's good news for investors in mortgage pass-through funds, which have suffered from the high volume of prepayments in 1993. Capital gains, if any, are likely to be modest in this market, but because of the expected decline in prepayments, returns will also be less volatile.
Some money managers worry that lower fixed-income returns could prompt unsophisticated investors to reach for yields even more than they have done in the past. This year, for example, buyers of funds loaded with so-called "interest-only" instruments watched the value of their investments plunge 50% or more. Inevitably, Wall Street alchemists next year will offer investors new and untried securities to satisfy their thirst for higher yields. Some of these will contain derivative instruments. Money managers point out that when used as a hedging device, derivatives are a useful technique. But they warn that derivatives combined with leverage can be a formula for disaster, especially if interest rates rise. If such an investment promises returns much higher than those available on similar plain-vanilla instruments, watch out. Says MFS Senior Vice-President Leslie J. Nanberg: "If certificates of deposit are at 3% and someone offers you a fund yielding 10%, that doesn't necessarily mean its a bad investment, but it certainly is a riskier one."