Online Extra: Bonds: What a Difference a Decade Makes

Back in 1994, a Fed tightening cycle wreaked havoc. History isn't likely to repeat this time around. Here's why

Even though fixed-income investors anticipate that the Federal Reserve will start hiking short-term interest rates on June 30, the bond market is still gripped by a considerable amount of angst. Investors to seem think "there will be some crisis when rates go up," says James Paulson, chief investment officer at Wells Capital Management.

That's because they fear a repeat of 1994, the worst year for bonds in decades. At that time, the Fed surprised the market in February, and short-term rates shot up from 3% to 6% in about 12 months. Many investors lost money because they bought bonds after each incremental increase, thinking the Fed was done raising rates.

Sure, the 1994 and 2004 bond markets have much in common. In both cases, the fed funds rate fell steadily and stayed there during the three years leading up to the tightening, says Jeffrey Phlegar, co-chief investment officer of fixed income for AllianceBernstein. And, of course, the economy was growing at a healthy clip -- 4% for 1993 and 5% for the last four quarters -- prior to the Fed taking action.


  But the similarities end there, say many bond pros, and they seem to be more optimistic this time around. "I don't think the outcome of this rate-tightening cycle will be as troublesome, because we have the benefit of the 1994 experience," says Ward McCarthy, managing director of Stone & McCarthy Research Associates.

"The market is better prepared for this cycle." As evidence, investors have already sold enough holdings to push the 10-year U.S. Treasury bond up 1.4 percentage points from its low a year ago.

Foreign capital can also give support to the bond market. "Money from overseas has helped to moderate the rise in rates that has occurred so far," McCarthy says, and those investors weren't in the U.S. bond market in 1994. Indeed, for the 12 months ended this March, foreign investors purchased $390 billion worth of U.S. Treasuries, $271 billion worth of corporate bonds, and $170 billion worth of agency debt. That compares to $79 billion, $38 billion, and $22 billion, respectively, in 1994. With the U.S. running a huge trade deficit, "foreigners don't have a choice but to invest their dollars in our fixed-income securities," says McCarthy.

Inflation is another touchstone that bond pros watch to monitor how aggressive they think the Fed will be with its rate tightening. This time around, rising prices aren't nearly as threatening as in 1994. Back then, core inflation was running 2.6% annually notes AllianceBernstein's Phlegar. The current 1.6% annual rate is significantly lower.


  Finally, industrial activity also isn't as strong now as it was 10 years ago. Capacity utilization was a strong 82% in 1994, while it now stands at only 75%, says Phlegar.

No doubt, an unanticipated spike in inflation could spook the bond crowd and turn a cyclical adjustment in interest rates into a rout. More likely, though, the damage to the bond market will be less than the veterans of 1994 saw back then.

By Toddi Gutner in New York

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