Temporary Insanity In Bonds

The sell-off may be scary, but it's not the birth of a bear market

Wall Street hadn't seen anything like it since the bond market bloodbath of two years ago. In only two weeks, prices plunged nearly $50 on each $1,000 bond, driving the yield on the benchmark 30-year U.S. Treasury bond from 6.03% to 6.47%. "We had thought the next general move in interest rates would be up," says Ian A. MacKinnon, who is responsible for the management of $70 billion in fixed-income funds at Vanguard Group. "But we were not prepared for the magnitude or the suddenness of the move."

Just about every major player in the bond market would agree with MacKinnon. Trouble is, that's what they said in early 1994, at the beginning of what turned out to be the worst year for bonds in six decades. That's why the latest spike in rates has sent shivers down the spines of many bond investors and thrown cold water on the superheated stock market. But if the first two months of 1994 and 1996 look uncomfortably alike, rest assured: The sell-off is not the start of a new bear market. "We're still on the long-term secular path of disinflation," says William H. Gross, the chief investment officer for $75 billion in fixed-income accounts at PIMCO Advisors L.P. and a bond-market bull. "Nothing's changed in recent weeks that would alter that."

A short-term drop in bond prices should not have come as a total surprise. Bonds had been on one hell of a roll, with prices climbing 35% and rates falling from 8.2% to 6% in a little more than a year without a significant correction along the way.

Part of that rise came from hedge funds. These private partnerships, which are generally run for the benefit of high-net-worth individuals, were buying U.S. Treasuries on money borrowed at rock-bottom interest rates in Japan. That was a sophisticated investment scheme that depended on Japanese interest rates staying low, the dollar remaining strong, and bonds at least holding their prices. But in recent weeks, Japanese rates have risen and the dollar has weakened. Particularly hard hit are the funds that make big investment bets on macroeconomic trends in bonds and currencies. "There are some `macro' funds with as much as 25% loss in February," says Steven Lonsdorf, executive vice-president of Van Hedge Fund Advisors Inc. George Soros' Quantum Fund, the largest of the macro funds, is down roughly 8% for February. Tiger Management's funds were even for the month.

Worried about the possibility of further dumping by hedge funds, many other bond investors have been apprehensive about stepping up and buying. "A 6% yield offers no protection against adverse developments," warns John P. Lipsky, chief economist at Salomon Brothers. "So any bad news hits the market pretty hard."

The Presidential election hasn't helped matters. Until recently, Wall Street assumed that Senator Bob Dole was a shoo-in for the Republican Presidential nomination and that there would soon be a balanced-budget accord--the Holy Grail of the bond market crowd. But now Dole, the candidate who was the strongest advocate of a balanced budget, is weakened, and the budget is a nonissue with his chief challengers. Publisher Steve Forbes espouses a flat tax and supply-side economics, and right-wing firebrand Pat Buchanan rants and rails against Wall Street and big business.

BUYING OPPORTUNITY. The economy is also perplexing some investors. Federal Reserve Chairman Alan Greenspan's delphic testimony before Congress on Feb. 20 and 21 led many to conclude that the next Fed easing--perhaps at the March meeting--will be its last, leaving the rate at which banks lend to one another overnight around 5%. The market had been hoping for subsequent cuts, so many disappointed investors sold out.


Others, though, think the economy is unlikely to show much strength, and could even be heading toward a recession. That's good news for bonds. "The amount of borrowing has been going down, banks are tightening credit standards, and delinquencies for credit cards and mortgages are going up," says John Capodici, a senior bond manager at Glickenhaus & Co. "That's all positive for the bond market."

So is the inflation outlook. The January producer price index came in at 0.3%, lower than many economists had forecast, and the consumer price index of 0.4% shows inflation is still in check. If that kind of favorable inflation news continues, investors could start buying again in spite of the political turmoil. Indeed, the current bond market woes may turn out like most corrections--an excellent buying opportunity.

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