Bonds May Still Be Good Bet, Even at Current Yields

Everybody was bullish on bonds late last year. And for once, everybody was right.

If you bought a 30-year Treasury bond in mid-October, you picked up a yield of 9.05%. Buy the same issue today and your yield is just 7.99%.

So the bond crowd knew what it was doing locking in rates. But now what? If you have money to invest, are bonds still worth it--or should you opt for stocks or something else?

Since early this month, the 30-year T-bond yield has stalled right around 8%. The story is much the same on medium-term issues. The yield on seven-year T-notes is about 7.7%, flat this month.

If you look at what “everybody” is saying now, the expectation is that the Federal Reserve is going to ease credit further to help re-energize the economy. But the Fed directly controls only very short-term interest rates, such as on three-month T-bills. Even if the Fed pushes those rates lower, the direction of longer-term rates will depend on what investors want, not on what the Fed wants.

Which brings up a good historical reminder: Since 1974, the 7.5% to 8% range has been the floor for long-term T-bond yields. That’s a formidable, time-tested psychological barrier. “We are getting down to the nitty-gritty now, in that we have reached these resistance levels,” says Robert Di Clemente, economist at Salomon Bros.

To accept much lower bond yields, investors are going to have to be persuaded that something major has changed. And to a bond investor, nothing is more major a concern than inflation.

The government today reports the consumer price index for January, and a fairly mild rise of 0.3% is expected. In 1990, the CPI rose 6.1% for the year. This year, many economists believe that the inflation rate will fall to about 4% in the recession.

To bond investors, any inflation is bad, because it erodes the value of bonds’ fixed returns. The question confronting would-be bond bulls is, if we do get 4% inflation, is that low enough to justify bond yields below the 16-year floor of 7.5% to 8%?

Take a look at the accompanying chart, and you’ll see why that floor is going to be very tough to break through. In the mid- and late 1970s, bond investors were constantly playing catch-up, as inflation rose faster than bond yields. Bonds were a loser’s game--your return was eaten by inflation.

In the 1980s, even as inflation fell to a stable 4% annual rate from 1983 through 1988, investors refused to bring bond yields down much below 8%. After the beating they took in the 1970s, who could blame them? They wanted to make sure their returns far outpaced inflation.

It may be a brand-new decade, but there’s no sign that bond investors have lost their paranoia about inflation. So now that long-term bond yields have fallen again to that historical floor, “I think the market is going to be in a show-me mode from here on out,” says Di Clemente. If 4% inflation is the best we can do this year, bond investors may not accept much less than 8% yields.

By the same token, it’s hard to imagine interest rates rising soon, with the global economy slowing markedly. For bonds, a stalemate may be here.

That leaves potential bond investors in a not-so-bad situation. If you buy now, and rates just level out in 1991, you’ll earn a 7.5% to 8% annual yield. That beats 6.5% money-market alternatives.

Can the stock market match 8%? The Dow Jones average has risen 11% year-to-date, to 2,932.18 as of Tuesday. But from here on out, to equal an 8% bond yield, the Dow would have to finish 1991 at 3,167, up another 235 points.

Certainly, some stocks will easily gain 8% between now and the end of the year. But Anthony Brown, manager of the $133-million Pax World mutual fund in Portsmouth, N.H., figures he is safer buying bonds than stocks now, overall.

The Pax fund is a “balanced” fund that owns both stocks and bonds. Last year, the fund gained 10.5%, while the vast majority of mutual funds slumped. Brown was a savvy market timer all through the late 1980s. Last spring, he had 65% of his assets in stocks, and just 35% in bonds. Now, he’s headed for 45% stocks and 55% bonds.

The stock market has simply gotten ahead of itself, Brown says. “When the Iraqis give up en masse , that’s going to be as good as it gets” for stocks, he says. Hit the market for a 15% correction, and he’ll be back in, Brown says. Otherwise, the 7% to 7.5% yields he is earning on two- to five-year Treasury notes suit him just fine.

For aggressive investors, Brown’s risk-averse approach may be too dull. But for cautious folks who are afraid of stocks’ heights--but who also are sick of piling up cash in money market accounts--bonds may still be the best choice.

T-Bond Yields and Inflation Are long-term Treasury bond yields ready to drop sharply below the 8% level? History suggests that can’t occur unless we’re headed for a sustained period of very low inflation-back to the1960s. Source: Salomon Bros.