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Over the last five years, it has been pretty hard for an investor to justify anything other than buying stocks. Since 1996, the Nasdaq has tripled, while the Dow and the S&P 500 more than doubled. In the same period, the Lehman Aggregate Bond Index was only up by 32.5%.
This year, however, the tortoise is outpacing the hare. The Lehman Aggregate Bond Index has had an 8.17% return year-to-date. By contrast, the Nasdaq has dropped roughly 25%, while the Dow and S&P 500 indexes are off 7%. And now, with the Presidential election outcome in temporary limbo and the economy apparently slowing, a safe, stolid bond portfolio looks rather attractive to many worried investors.
But bond markets can be treacherous -- and bonds aren't rising uniformly with the current investment tide. "We forget that all bonds are not created equal," says Marci Rossell, chief economist at Oppenheimer Funds. "High-yield bonds are a very different proposition from government or municipal bonds." And the high-yield sector is having its problems.
In general, government and muni debt are producing stable returns, while corporate credits are having mixed results. The market is keeping a wary eye on oil prices, inflation, and the Federal Reserve -- as well as the drawn-out election process. The uncertainty about the elections may be creating a buying opportunity by heightening the bond market's general illiquidity and pushing up interest rate spreads over U.S. Treasury debt. That could make some corporate bonds a buy. But it pays to be selective.
DEFENSIVE STRATEGY. In this situation, Matthew Kuhns, a vice-president and portfolio manager at Transamerica Investment Management, recommends a conservative approach. He's putting his money in good old-fashioned Old Economy companies that sell things like consumer goods and electricity. "These are defensive investments," Kuhns says. Among the investments he likes is the recent $7 billion bond issue by Europe's Unilever. The company is very solid, and Kuhns likes the fact that the issue has multiple maturities.
Many investors, however, still seem wary of buying bonds. Despite better bond returns this year, a net $45 billion, or 5% of total taxable and nontaxable bond funds, flowed out of bond mutual funds in 2000, according to Investment Company Institute data. However, Robert Smith, president of Smith Affiliated Capital, says part of the pullback is happening because investors worry that they can't redeem mutual-fund investments as quickly as they might like. Smith believes investors are using separate accounts to invest selectively in bonds.
Bond investors have every right to be fretting about credit quality. High-yield bonds have been plagued with problems. Some big-name companies -- including Xerox, J.C. Penney and Rite Aid -- have been hit hard. So have entire industrial sectors, such as movie-theater management companies and junk-rated phone-company issuers.
"A TOUGH YEAR." The current liquidity crunch has exacerbated these problems. "When something goes bad, and the market is illiquid, the yield changes by 20 to 30 basis points [0.20 percentage points to 0.30 percentage points] instead of by two or three basis points [0.02 percentage points to 0.03 percentage points]," says Transamerica's Kuhns. Many big-name corporate bonds are trading at 40% to 50% discounts to par value, Kuhns points out.
Aside from specific hard-luck stories, Kuhns and others see an overall deterioration of corporate credit quality that the market is trying to price in. "Corporate bond spreads have had a tough year," says Kuhns. "The rate on 10-year interest-rate swaps [a bond market bellwether] is at 117 to 119 basis points [1.17 percentage points to 1.19 percentage points]. That's even wider than in a recession year." By contrast, in 1990, a year when the economy was weak, spreads were at a all-time high of 80 basis points [0.80 percentage point].
This year, however, the economy is fundamentally sound. And the market apparently is not expecting further Fed tightening or runaway oil prices that would feed inflation. "If you look at the Fed funds futures, the market has priced in an easing [of interest rates]," says Oppenheimer's Rossell. "If it thought that oil was going higher, you wouldn't see futures pricing assuming that inflation was dropping."
WIDENING SPREADS. The big question investors have to ask is: How much credit risk do you want to take? The yield gap is widening all the way down the credit spectrum. Triple-A corporate bonds with a 10-year maturity are yielding returns of 170 basis points (1.7 percentage points) above 10-year U.S. Treasury bonds. In addition, spreads between different credit classes of corporate bonds are widening, with the difference between the yield on a single A- or double A-rated corporate and a single B- to double-B rated corporate increasing 2 percentage points the past month. "High-yield debt is all over the map," says Mike Ryan, senior fixed-income strategist at UBS Warburg.
At least part of what accounts for the increasing divide between Treasury rates and corporate rates is the U.S. government's buy-back program. The Treasury accomplished its avowed goal of repurchasing $30 billion of debt this year. As Treasury bonds become more scarce, their prices rise and their yields shrink. On Nov. 15, the 10-year Treasury was yielding roughly 5.77%, a decrease of 0.12 percentage points from a week earlier.
The buyback program has caused the yield curve to invert -- short-term rates have been higher than long-term rates -- for most of 2000, a trend that may well reverse in 2001. In general, the longer the maturity of a bond, the more an issuer needs to reward a bond buyer for tying up his money. Because the Treasury began buying back bonds with 30-year and 10-year maturities, the yield curve inverted, and two-year Treasuries yielded as much as 0.70 percentage points more than 30-year Treasury bonds. That inversion spread has narrowed considerably to only a couple hundredths of a percentage point in recent weeks. The two-year Treasury is yielding around 5.87% and the 30-year is at around 5.85%.
CHOOSE YOUR POISON. But the buy-back program may not last. The bond market appears to be pricing in expectations that the U.S. budget surplus will dry up next year, which could cause the program to be abandoned. "The way the market sees it, if Gore gets in, government spending will go up, if Bush gets in, there will be a tax cut. Either way there won't be the same surplus," says Transamerica's Kuhns.
Meantime, the election debacle is causing investors to sit on the sidelines, which tightens the bond market's liquidity crunch. "Liquidity gaps happen during times of financial market angst, and this election is a big uncertain event," says UBS Warburg's Ryan. Once the election is decided, the bond market should be a little more liquid.
Over the long haul, bond returns certainly can be alluring. "The long-term return on stocks, including the bull market is around 11%," says Kuhns. "You can do that with high-yield bonds. There are buying opportunities if you're selective." For investors tired of seesawing stock markets, some cautious investments in bonds may be just the ticket.
Popper covers the markets for BW Online in our daily Street Wise column Edited by Thane Peterson
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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