The Party Winds Down In The Bond Market

Economics may be the dismal science, but it's difficult to find an economist these days with a dreary 1996 forecast. That said, even those who expect short- and long-term rates to decline a bit further next year generally agree that most of the juice has already been squeezed out of the bond market. And they warn that investors hoping for continued capital-gains-driven double-digit returns had better be prepared to look elsewhere.

The consensus of economists is that the nation's growth rate, as measured by gross domestic product, will slow next year, but they believe that consumer inflation will remain steady at a moderate 2.8%.

TOO ROSY? And most Fed watchers think that the central bank will cut the benchmark Fed funds rate by at least half a percentage point by the end of the first quarter. Some, such as Merrill Lynch & Co. and the WEFA Group, believe that the economy will grow somewhat faster and that the rate of inflation will be somewhat lower than the consensus. They also think the market is a bit too optimistic about the longer-term prospects for budget reduction. Andree-Anne Desmedt, WEFA's director of U.S. Financial Services, believes the long bond will inch up to 6.3% by late next year. Martin J. Mauro, senior economist at Merrill, is looking for 6.45%.

More bullish on the bond market is Neal Soss, principal of Soss & Cotton, a New York economic consulting firm, which expects no unpleasant surprises in 1996. The firm projects 2% inflation, 2% GDP growth for the year, and a 5.5% 30-year bond by yearend. "It's pretty hard to come up with a sector of the economy that's shockingly strong," he says. His argument: The consumer is cautious, and housing starts and sales appear to have leveled off. Capital spending is slow, and industrial capacity utilization is at a noninflationary level. Commodity prices are in check. Low rates in Japan relative to those in the U.S. should keep Japanese investors keen on Treasuries. And while wage pressures have become a concern at the Fed, Soss isn't worried.

So what does this generally benign economic outlook mean for bond investors?

If there is one sector of the fixed-income market that almost all strategists agree is the most attractive, that sector is municipal bonds. Supplies of munis have shrunk dramatically because of state and local government belt-tightening. That, coupled with exaggerated fears that Congress will enact tax reforms with a flat tax as the centerpiece, make municipal bonds a bargain for individuals in the top tax brackets. Right now, yields on tax-free securities relative to those on the 30-year Treasury bond are around 90%.

BIG BITE. A word of caution: With today's low interest rates, it doesn't take a big increase in yields to take a big bite out of the principal on longer-term instruments. "An inflationary bias" could spell danger for the small investor, warns A. Keith Brodkin, chairman and CEO of Massachusetts Financial Services Co.

In the taxable sector, governments in the five- to seven-year range look like a good bet if the economy grows slowly. Ian A. MacKinnon, senior vice-president of the Vanguard Group, who advises shortening maturities, points out that investors who drop back from 20-year to 10-year issues give up just 25 basis points in yield. With little threat of a recession in the next year, experts think that high-quality corporate bonds as well as junk issues should also perform reasonably well.

Bond-market gurus think mortgage-backed securities, notably Ginnie Maes, which are now yielding about 7%, also hold promise in this era of low rates. But they differ a bit on when the investor should strike. If rates fall sharply enough to trigger a rush of prepayments, investors will lose some of their principal. William H. Gross, managing director of Pacific Investment Management Co., which runs the nation's largest fixed-income portfolio, says he would wait until the Fed funds rate falls to about 5%. Mortgage funds, he says, "could be the best buys of 1996."

There are other niches--albeit not many--in the bond market where individual investors can eke out above-average yields without losing too much sleep over principal. Gross and others think preferred shares of some foreign banks are worth considering. Dividend yields on A-rated preferreds issued by Spain's Banco Santander and Banco Bilboa Vizcaya are running upwards of 9%. Because Germany's economy is sluggish and inflation is low, Gross also likes Germany's 10-year "bunds," now yielding about 6.125%. These are available as individual issues as well as in global bond funds.

Another fruitful niche is closed-end bond funds. Gross points out that discounts on many closed-end bond funds have lately widened to as much as 15%, allowing investors to pick up some gains there. To do so, says Thomas J. Herzfeld, head of a Miami money-management firm bearing his name, investors should act soon because of what he calls the "December phenomenon." Fund investors with paper losses tend to sell these issues in December to take tax losses before yearend. Thus, discounts tend to widen in December and contract in January.

Herzfeld likes funds trading at above-average discounts, such as the BlackRock 2001 Term Trust, which is selling at a 15% discount. He expects the discount to shrink by five percentage points by January. And for the fixed-income investor with a healthy appetite for risk, Gross recommends bond funds containing issues of Argentina, Brazil, and, yes, even Mexico, in the relatively stable interest rate climate he expects next year. Some of these funds are now yielding as much as 15%.

Last year, Vanguard's MacKinnon predicted--incorrectly, as it turned out--that 1995 would be the "year of the coupon" rather than a year of fat capital gains. He reiterates that prediction for 1996. But this year he may be right.

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