SPECIAL REPORT: INVESTING IN THE ‘90s : BONDS : A Cloudy Crystal Ball Means, Hedge Your Bet

Nobody can predict interest rates with any consistency. But today, everybody seems to be trying. And for no group are the perceived stakes higher than for the millions of investors who own bonds or bond mutual funds.

If interest rates rise, or inflation steams up, most bond investors know one thing: They lose. Because a bond’s return is locked in for its life, that bond becomes less valuable if new bonds pay more. Its value would also be eroded by higher inflation.

What bond investors want in the ‘90s is more of what they’ve grown accustomed to: Falling interest rates and falling inflation, both of which make older, higher-yielding bonds leap in value.

While the seesaw mechanics of the bond market are as old as bonds themselves (circa 1700, in Europe), none of this became a national obsession until the 1980s. That was when individuals moved into Treasury, corporate and municipal bonds in a big way to grab the unprecedented double-digit yields of that era.

Over the last three years, as the weak economy has allowed short-term interest rates to fall to 30-year lows, the hunt for yield has sent a new army of individuals marching out of 3% bank CDs and into 6% to 8% bonds.

Now, perhaps millions of trigger fingers are waiting for a sign that the economy is ready to boom. Or that inflation is creeping back. Or that President Clinton won’t rein in the federal budget deficit.

Any of those signals could mean the long-dreaded turn in interest rates--a rise in rates that could send bond owners fleeing back into money market funds and other havens, to preserve their capital.

Is it time to anticipate that reversal of fortune and sell bonds?

There are good arguments that the bond party fueled by 12 years of (mostly) falling interest rates can’t go on much longer. For one, bond returns since 1989 have been nearly as good or better than returns on stocks, depending on the type of bond.

In theory, that shouldn’t happen for any sustained period. The higher-risk investment--stocks--should triumph in the long run.

Neil Dabney--whose Beverly Hills firm, Dabney/Resnick Asset Management, is a major player in high-yield junk corporate bonds--cautions that even that red-hot market has seen its best days for awhile. At most, the top tier of junk issues may produce overall returns of 10% to 12% a year, he says.

As for the rest of the bond market, including Treasury issues, Dabney says: “When interest rates were high in the ‘80s, I felt compelled to buy long-term bonds. I’m not buying them now.”

Yet many Wall Street pros find predictions of an imminent sharp rise in rates hard to support.

“I still believe we are in a period of very slow economic improvement,” says Stephen Lieber, manager of the $112-million Evergreen Foundation stock and bond mutual fund in Purchase, N.Y.

Without fast growth, he asks, where is the demand for money that would drive interest rates higher? Finding no real threat to the status quo, Lieber is keeping 32% of his fund’s assets in Treasury bonds maturing well into the next decade. The rest is in stocks.

John C. Bogle, head of mutual fund giant Vanguard Group in Valley Forge, Pa., cautions investors against becoming too focused on how far bond yields have slid since the mid-’80s--and the odds of a return to those old highs.

What’s important going forward is simply whether the yields offered on bonds today are attractive relative to inflation and the alternatives, Bogle says. With long-term Treasury bond yields near 7%--while money funds pay 2.7%--he reckons bond owners are still in the right place.

In fact, Bogle believes that stock investors have more to worry about, given stocks’ sky-high prices relative to earnings. “With bonds paying 7%, the challenge is for stocks to do better” than bonds over the decade, he argues.

However, even rosy scenarios for bonds in the ‘90s must account for volatility along the way. Interest rates may spike a point or two periodically. The question thus becomes, how much of your principal can you stand to lose--even if just on paper, and just temporarily?

The math can be sobering: If you own a 10-year bond that yields 5.9% annually, and if similar new bonds pay just 0.5 point more a year from now, your bond’s paper value would be 3.7% less. Subtract 3.7 from 5.9, and your “total return” over that 12-month period would be just 2.2%.

Those are the kinds of numbers that frighten many bond investors, and rightly so--especially when a drop in value is as obvious as the decline in the daily newspaper price of your bond mutual fund.

There remains, nonetheless, one overriding issue for most bond owners: Do you live on your investment income? If so, you probably have little choice but to remain in bonds until--and if--short-term interest rates move significantly higher.

So rather than try and predict rates, your goal should be to hedge your bet for whatever happens.

The key is diversification--not just owning a bond mutual fund instead of a single bond, but owning different types of bonds, some shorter-term and some longer.

Margie Mullen, who runs her own non-commission financial planning firm in Los Angeles, says a typical income-oriented client’s portfolio today might be divided into four pieces: 30% in a long-term corporate bond fund, 20% in a short-term corporate bond fund, 20% in an international bond fund and 30% in high-yielding real estate investment trusts.

The long-term funds provide the income, while the short-term fund is a buffer if interest rates rise, Mullen explains. The international bonds can balance against weak performance by U.S. bonds. The REITs provide growth potential.

The beauty of this approach is its simplicity and logic. The bond market, demystified, is just a game of allowing for possibilities.

Tracking Interest Rates

Interest rates have been declining steadily for more than two years, and the long-term trend has been downward since 1982. Many experts believe that rates are more likely to go up than down from here, although any upward move may be modest.

Long-term Treasury bond yields, annual average (In percent): 1993: 6.82%

Note: Rates are averages of Treasury bonds maturing in 10 to 30 years.

Source: Federal Reserve