This Rally Still Has A Full Head Of SteamDean Foust
How low can yields go? That's the burning question among bond investors in light of the explosive rally in fixed-income markets since last November. With bond prices soaring on the evidence that the economy has slowed sharply, the yield on the benchmark 30-year Treasury has plummeted from 8.25% late last year to 6.5% on June 6. Bond yields are plunging abroad, too. And with the recent spate of bearish economic news worldwide, forecasters are betting the rally won't end anytime soon in U.S. or overseas markets. While the European markets offer value, fund managers and economists believe the story in the U.S. is the most compelling: "Invest in America," says Madis Senner, manager of Van Eck Global Income Fund. "Buy bonds."
But more may be at work here than a cyclical slowdown in the economy. Indeed, the current rally may reflect a fundamental change in economic expectations that could have a long-term impact on interest rates. For one thing, economists are becoming convinced that the Federal Reserve has finally tamed the inflation that wreaked havoc during the 1970s and 1980s. Moreover, the markets believe the Republican leaders in Congress will make good on their pledge to slash the federal deficit.
FAMILIAR REFRAIN. Economists are beginning to argue that bond yields could move back toward the historical range of the 1950s and 1960s--roughly 2.5 to 3.5 percentage points above the inflation rate. That compares with a 5- to 6-point premium investors demanded during the 1980s. With inflation expected to tick up slightly above 3% this year, Philip Braverman, chief economist for DKB Securities Corp., says the 30-year Treasury now has room to dip to around 6%. Other forecasters expect bigger drops over the long run: "Investors are going to see long bond yields drop below 5% over the next five years," says Tokai Bank Ltd.'s chief economist, Robert T. McGee.
Predictions of a 5% long bond sound hauntingly familiar to the refrain bond traders sang a mere 18 months ago before they were caught flat-footed by a series of Fed rate hikes. And some experts believe the current surge doesn't just reflect fundamentals. They say the market may have gotten ahead of itself because of short-covering by traders who bet wrong and heavy buying by managers of mortgage-backed securities funds. As homeowners have rushed to refinance mortgages, these fund managers have seen the value of their mortgage-backed securities drop. To bolster returns and try to match the rates they expected to earn on their mortgage-backed securities, fund managers have been buying long-term Treasuries. "The market is getting a little frothy here and forcing a lot of people in from the sidelines," says Leslie J. Nanberg, chief fixed-income officer at Massachusetts Financial Services Co. That's why some economists believe that bond prices could go back up, sending yields toward 7%.
Given the steady drumbeat of souring economic news, such a correction seems increasingly unlikely. With the economy beginning to shed jobs, industrial production falling, and consumer confidence slipping, economists believe the Fed could cut short-term rates by a half a point, to 5.5%, as early as July. That would be all the bond market needed to take off again. "I expect the powerful rally to continue," says Vernon R. Barback, head of fixed income at Bankers Trust Global Investment Management.
What does this mean for U.S. investors? With interest rates trending down over the long run, you would want to buy Treasuries with long maturities--even 30-year bonds. That gives one the biggest potential for capital gains. For example, if you bought a 30-year bond on June 5 with a yield of 6.53% and rates fell immediately to 6%, the price of the bond would rise 10.5%--on top of the stream of interest payments you would receive. More conservative investors might consider buying 10- or even 5-year bonds, which are less volatile. If rates go back up, the market value of shorter-term bonds will fall less than the market value of 30-year bonds. But with the flat yield curve (chart), you'll earn almost the same interest income as you would by purchasing bonds with longer maturities.
LATIN SETBACK. Bond traders also smell opportunity in Europe, where growth is slowing partly because of a weak dollar that will crimp exports. While the bellwether German economy should grow a brisk 3% this year, Germany's manufacturing sector--which exports 20% of its output--is beginning to show signs of strain from the strong mark. "Europe is starting to slow more than people expect," says Howard Flight, joint managing director of Guiness Flight Capital Asset Management Ltd. in London. With the Bundesbank expected to cut rates later this year, Flight predicts that yields on German long bonds could drop below 6% from their current 6.5%.
Outside of Germany, the best value in Europe may lie in Ireland, says Daniel J. Fuss, head of fixed income at Loomis, Sayles & Co. He notes that Dublin has quietly slashed its outstanding debt to a relatively low 2% of gross domestic product. And Margaret Craddock, vice-president at Scudder, Stevens & Clark Inc., likes the Dutch bond market. But she advises against wading back into Latin America, which is still suffering from the aftershocks of the Mexican financial crisis that followed last December's botched peso devaluation. "Unemployment is not just a statistic in Latin America," says Craddock. "There's real political risk in some of these countries."
That's hardly the case in Canada, however. In fact, Andrew Skirton, head of fixed income at BZW Investment Management Ltd. in London, thinks the beleaguered Canadian dollar will recover to become "the world's strongest currency over the next six months." He thinks overseas investors will pile into Canada as the country achieves reductions in its yawning budget deficit and Quebec's independence drive stalls. Now yielding 140 basis points over U.S. Treasuries, Canadian government bonds "are cheap," he says.
Many pros are finding it harder to locate compelling values among U.S. corporate bonds. They worry that corporates no longer carry enough of a risk premium for investors to spurn Treasuries in favor of corporates. The spread between the two--historically 0.75 percentage points for a 10-year corporate bond rated A and a ten-year Treasury--is currently 0.6 percentage points. If the old pattern returns, buyers of corporate bonds could get burned. "There's no advantage to owning single-A-or-better bonds," notes Loomis Sayles's Fuss. "The excess income is so narrow that if spreads widen, they [the bonds] could provide lower returns than Treasuries for a couple of years."
The experts urge extra caution when buying junk debt. "If you think we're going into a recession, that's where the risk is greatest, with deceleration in credit quality," says Nanberg at Massachusetts Financial. Still, investors who are willing to take some risk can find some values in corporates, particularly among companies whose credit ratings are likely to be upgraded. Fuss has been buying Digital Equipment Corp.'s four outstanding debt issues, notably its 8.625% notes maturing in 2023 and its 7.75% paper due in 2023. DEC debt now fetches a BB- rating from Standard & Poor's Ratings Group. But Fuss thinks DEC's success in personal computers and its Alpha microprocessor--which have lessened its dependence on a faltering line of midrange computers--should soon allow the company to regain investment-grade status.
STRONG JUNK. Bradley C. Tank, a portfolio manager at Milwaukee-based Strong Funds, meanwhile, sees values among media companies, auto and steel producers, insurers, and regional banks. In fact, he is snapping up the paper of banks he thinks could be takeover candidates in the next couple of years, including Union Planters Corp. of Memphis and United Jersey Bancorp. The paper of both institutions carry BBB ratings from S&P, but Tank believes they would receive an upgrade after a takeover, since the buyer most likely would carry an A rating or better. "They could become single-A credits overnight," he says.
Kingman Penniman, who tracks the junk market for Duff & Phelps/MCM Investment Research, favors Bally's Health & Tennis' 13% senior subordinated notes maturing in 2003, yielding 15.3%, and Showboat's 13% senior subordinated notes due in 2009, currently yielding 12.4%.
But you may not have to go to such high-risk extremes to make a good return in bonds this year. With the global economy slowing and inflation subdued, all signs suggest the market rally of 1995 has lots of life left to it.
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