Economic Good News Is Bad News for Bonds

THIS year has not been kind to the United States bond market and the millions of Americans who own bonds. Higher inflation and rising interest rates have slashed the value of many existing fixed instruments.

And the bond market woes are not necessarily over. Many economists predict that the Federal Reserve will continue raising interest rates into the spring. That means additional turbulence in the bond market, as fixed-income investors react nervously to almost every sign of strong economic growth. The bond market is historically skittish about ``good'' economic news, such as higher housing starts and lower unemployment statistics.

Since early February, when the Fed first raised rates this year, yields have moved steadily upward, while the price of existing bonds has dived. Bond yields and prices move inversely. Investors have shifted large sums out of fixed investments into equities and other vehicles such as short-term money-market funds.

The bond market was pummeled again last week, following several reports of continuing robust US economic growth. Yields on 30-year Treasury bonds shot up to almost 8 percent on Oct. 20, the highest level since May 1992. Meanwhile, the price of the 30-year bond fell 1-1/8 points, or more than $11 on a bond with a $1,000 face value. On Friday, the yield on the long bond fell slightly to 7.97 percent, though the easing looks short-lived.

Downward pressure on bonds also hit the stock market last week, as investors sought safety by shifting assets into cash. Part of Wall Street's concern is historical: It's remembered that turmoil in the bond market in the summer and fall of 1987 preceded the massive stock market crash in October. Still, yields on long bonds were at 10.5 percent in September 1987, compared with around 8 percent now.

Although money continues to roll into fixed-instrument mutual funds, the aggregate amount has dropped sharply. Through Aug. 31, bond funds this year have rung up $27 billion in net sales, according to John Collins, a spokesman for the Investment Company Institute (ICI) in Washington, a trade group for the mutual fund industry. That compares with net sales of $101 billion during the same eight-month period in 1993. At the end of August, investors had parked $728 billion in bond mutual funds, compared with $761 billion in fund assets at the end of 1993.

Many investors are now moving from bond funds to money-market funds, Mr. Collins says. Until investors feel more secure about both bond and equity funds, money-market funds are seen as ``safe havens,'' he says.

Investment strategists Rao Chalasani and Carl Bhathena of Chicago-based investment firm Kemper Securities Inc. hold that there is still risk in the long bond, with yields possibly hitting as high as 8.25 percent by mid-1995 or earlier.

Daniel Marcotte, director of fixed-income research for Minneapolis-based investment house Dain Bosworth Inc., agrees. He says he sees the long bond reaching around 8.25 percent later this year or early next year. ``The upward bias [on yields] will continue,'' he says, spurred by higher-than-expected economic growth. An ``overwhelmingly negative psychology has taken over the bond market,'' he adds.

Mr. Marcotte says the Fed will boost rates sometime soon, at least by the next meeting of the Fed's Open Market Committee, on Nov. 15. Some economists predict that there will be an additional rate hike in December.

Nonetheless, Mr. Chalasani of Kemper says he finds intermediate-term bonds appealing. Their five-to-eight year maturities make them less susceptable to inflationary pressures.

Municipal bonds also continue to win investor dollars, the ICI reports. Tax-free yields for long-term muni-bonds of 20 years or more are running around 6.5 percent. Given an inflation rate of around 2.7 percent, that means muni-bonds provide a real return of around 4 percent.