Sizing Up the Market

BONDS used to offer secure income from interest, a safe harbor for your money and no excitement whatever. Oh, how that has changed. jagged rises and falls in interest rates have sent bond prices plunging and leaping like a bronco with a burr under its saddle. Rates now fluctuate more in a day than they once did in a year. Since bond prices move as fast as interest rates, but in the opposite direction, the bond market is no longer a calm haven for the faint hearted.

A huge wave of corporate takeovers and leveraged buyouts has had its own unsettling effects. Takeover artists raise the money to buy the outstanding stock of a target company by getting Wall Street firms to underwrite huge bond issues secured by the assets of the corporation being acquired. In the ensuing financial restructuring, borrowings in the form of bonds replace equity in the form of stock, leaving the company far more heavily in debt than before. Takeover bonds therefore have low quality ratings. With more or less affection, investors call them "junk bonds." If the company being acquired happens to be a blue chip like RJR Nabisco, its old top rated bonds suddenly descend, price first, into the junk pile.

Despite the uncertainties in the market, Americans have gone on a bond buying binge. But many of the professionals who manage investments for banks, insurance companies and pension funds are apprehensive about buying long term bonds. They are afraid to commit money for decades ahead at fixed rates. What has the bond market on edge is worry that the U.S. Treasury must borrow so much to finance 12 digit federal budget deficits that interest rates may surge once again, causing bond prices to plunge. Of course, many other forecasters believe that the deficits will soon narrow and inflation will subside permanently, thus pushing interest rates lower.

Early in 1989, inflation fears helped to drive yields on U.S. Treasury bonds and top rated utilities above 10%. In the eyes of some strategists, that created an investment opportunity. If rates do head down again, the prices of bonds will go up. Sure enough, by mid 1989 rates were heading down again, and the prices of bonds were going up. In a swing like this, you can sell for a nice gain. Naturally, the risk you run when you buy is that interest rates could turn the other way around and climb beyond the yield you are getting. If you had to sell your bond at this point, you would take a loss.

Bold investors who are willing to trade actively may be able to profit handsomely from volatile interest rates. The principles of trading in fixed income investments are simple: To get the highest yields you should invest for as short a term as possible when rates are rising. Once you are convinced that rates have peaked, you should move into longer term securities to lock in those high yields and to reap any capital gains.

Prudence dictates caution in the bond market. But you can make sound use of bonds provided you understand the risks. For in and out speculators seeking quick capital gains, trading can be as attractive in bonds as in stocks. If you seek steady income, you can still find that old time safety, perhaps by buying Treasury bonds or the bonds of reliable, major corporations that are selling at deep discounts from their face values. For even greater safety, stick with Treasury bonds. No takeover onslaught can downgrade them, and they cannot be called in before their due date. Whether you choose corporates or Treasuries, however, if you are willing to take a risk with your principal, there may be an opportunity now to lock up 20 or 30 years of reasonable yields by buying long term bonds.