Pause in the Bond Boom

By Christopher Byron

Inflation fears could snuff the investment rush to fixed-income securities

When it comes to making big money quickly, thoughts of investing in bonds have not traditionally leaped to mind. Then came the summer of 1982, when declining interest rates gave the nation's $2.3 trillion bond market a spectacular liftoff, making born-again believers out of a generation of battered bondholders.

Though the stock market rally was better publicized, overall returns, counting capital gains as well as interest, made the 1982 surge in everything from US Treasury securities and corporate bonds to municipal bonds sold by state and local governments equally impressive. Investors racked up gains that approached 35% for ultrasafe investments in U. S. Treasury bonds and notes, with the rise in corporate and municipal bonds not far behind. The generous returns result when interest rates drop because bonds issued earlier at higher rates automatically become more valuable and shoot up in price.

For businessmen as well, the surge was gratifying. In recent years they have been borrowing heavily on a short-term basis to finance long-term projects a practice that Henry Kaufman, the celebrated credit market analyst at the New York investment banking firm of Salomon Brothers Inc., describes as "a little like trying to finance the building of one's house with short-term loans." Since the cost of most of that money has floated with the fluctuations in short-term interest rates, businesses have found investment costs hard to estimate in advance and have got burned as rates soared Now that long-term rates are at last dropping Kaufman predicts that corporations will sell a record $65 billion in bonds next year, up from $40 billion this year.

Yet hardly had 1982's bond market bulls had a chance to tot up their winnings when much of the euphoria that accompanied the rise in bond prices began to fade. Prices have begun to weaken ever so slightly, and interest rates have started to nudge upward. Reason: fear is spreading that inflation, a mortal menace for all fixed-income investments, could resume with a vengeance if the economy comes out of its doldrums. Says Raymond Dalio president of Bridgewater Associates Inc., a Connecticut-based economic and investment consulting firm that was strongly bullish on bonds last winter and spring but is much more cautious in outlook now We think there is perhaps some rise still to go for bond prices. But the big gains are over."

For the nation's weak and troubled economy, the bond market's sudden jitters could not have come at a worse time Interest rates have dropped dramatically since last summer, when even the highest grade corporate bonds yielded close to 14%. But triple-A corporate bond yields still hover above 11%, and lower rated issues provide yields substantially higher Those are levels that many economists feel are far too high for sustained economic recovery.

In fact, so-called real interest rates which reflect the cost of borrowing minus inflation, have actually increased slightly during the period because inflation has fallen faster than interest rates. Says C. Fred Bergsten, director of the Washington-based Institute for International Economics: "Interest rates must drop by two more points. It is critical for the U.S. and world recovery."

Bond buyers are demanding the high rates because they see so many things happening that could reignite inflation They fear, for example, that Washington's free-spending politicians will do litle to prevent a new price surge, leaving he fight once again to the U.S. Federal Reserve, which has carried the burden almost alone since 1979.

In particular, investors saw the congressional lameduck session just ended as yet more proof that the Government remains hopelessly incapable of reducing the nation's ever swelling budget deficit. Last week alone the Treasury issued $26 billion of bills and notes to help feed the Government's craving for cash, and the needs will grow as the federal deficit heads to a record $165 billion this fiscal year. One Treasury aide describes the borrowing outlook for early 1983 this way: "You can think of it as $5 billion a week, $1 billion a day or $125 million an hour."

Though not necessarily inflationary during a period of extreme economic weakness such as now prevails, the record Government deficits will prove hugely disruptive once the economy begins to recover. That is because the borrowings needed to cover them would tend to "crowd out" private corporations from the nation's credit markets, forcing interest rates to levels that would either choke off growth altogether or else compel the Federal Reserve to expand the money supply so rapidly as to rekindle inflation.

During the recovery from the last serious postwar recession of 1973-75, economic growth eventually gave way, beginning in early 1978, to a rebirth of high inflation. Then the Federal Reserve began to tighten up on credit to cool off the economy and bring inflation to heel. Yet making money scarce automatically makes it more costly, thus pushing interest rates up and sending bond prices skidding.

Having learned from bitter experience what can happen to their investments in a recovering economy, bondholders in recent weeks have grown wary and started cashing in on their spectacular 1982 profits while the economy is still weak. The selling has put further downward pressure on prices, which have slipped by an average of about 5% from their rally peaks. That in turn has helped hold interest high, and made businessmen and investors start to wonder if the cost of money will fall much farther under even the most favorable circumstances.

Yet in spite of the uncertainty, a long list of investment analysts and economists argue that interest rates are bound to keep falling in 1983 no matter what the economy does, making bonds still one of the best buys in all of finance. Not only are rates high, but inflation, for now at least, is in full retreat.

Further evidence of progress in the inflation fight came last week when the U.S. Labor Department reported that consumer prices rose during November by a mere 0.1%. As a result, inflation for all of 1982 now looks likely to remain under 5%, the lowest level in six years. Says David Levine, economic analyst for the investment firm of Sanford C. Bernstein & Co.: "The long-term outlook for bonds is bright indeed. The vast amount of slack in the economy will ensure that inflation will continue to decline even after the economy starts to recover."

Considering the economy's weakness, many experts argue that fears of crowding out in the market are also overblown. Reason: as companies increase their long-term borrowings, they are paring their short-term debt even more, thus easing their overall demand for credit.

What happens to bonds in 1983 will depend crucially on the Federal Reserve. Having stressed repeatedly since 1979 that it was determined to prevent the money supply from expanding out of control, the Fed since midsummer has allowed money to grow at an annual rate that is now approaching 17%, just about three times the bank's own officially announced 1982 target growth rate. Though the Fed has sought to play down the significance of the overshoot, investors are concerned that the growth will eventually prove inflationary, provoking the Fed to tighten up, sending interest rates soaring.

On the other hand, many experts believe that such fears are premature. Says Michael Evans, chief economist of McMahan, Brafman, Morgan and Co., a New York securities firm: "With the economy so weak, I think the Fed is just plain too scared to do anything except keep pushing out money for the foreseeable future. We've seen 15% money growth in the last quarter with no recovery in sight, so they'll probably keep pushing. To put it bluntly, the Fed will continue to buy up the Government's debt."

Ultimately, of course, too much money can wind up being as damaging to an economy as too little. While the Fed walks the razor's edge between economic collapse and runaway inflation, it badly needs the support of both the Congress and the Administration to curb spending, chop the deficit and prevent the nation's current economic troubles, and the bond market's jitters, from turning into something far worse. --By Christopher Byron. Reported by David Beckwith/Washington and Frederick Ungeheuer/New York

With reporting by David Beckwith, Frederick Ungeheuer This file is automatically generated by a robot program, so viewer discretion is required.