Knowing When Bonds Are Ripe for Picking

To conservative investors, bonds are a simple way to earn fixed interest payments. Earnings are slow, small and predictable.

But sophisticated and aggressive investors know that bonds--particularly Treasury bonds with long maturities--are one of the best and most exciting ways to profit from falling interest rates or a recession. The gain comes from the rise in the bonds’ value as interest rates fall. Earnings can be quick and big--but unpredictable and risky.

Last week’s column noted the size of potential profits: more than 60%, for example, on 30-year zero-coupon Treasury bonds if interest rates drop 1 1/2 points in 12 months.

And with more pundits predicting a recession--and a subsequent fall in interest rates--the subject of investment in long-term bonds has become more timely.

But timing is key. How do you know when to buy and sell so that you own bonds when rates fall rather than rise? Timing bond investments can be just as difficult as timing stock investments. “Even the professionals make lots of mistakes,” says William H. Gross, managing director of Pacific Investment Management Co., a Newport Beach firm that manages fixed-income portfolios for pension funds.

The risks of error can be high, as shown last week. Those holding long-term bonds or bond funds took a drubbing, as inflation fears triggered by Mideast tensions pushed long-term bond prices down 2.5% in just one day alone.

International tensions and inflation prospects are among several key factors you must consider in assessing an investment in long-term bonds. Among the factors:

* Is the Federal Reserve tough on inflation? Conventional wisdom is that Fed actions to ease credit, and thus lower interest rates, are bullish for bonds. That’s true--as long as you’re investing in bonds for only the very short run, such as a few weeks, Gross says.

But if you want to hold bonds for six months to a year or longer, the opposite is true, Gross says. You want a Fed that keeps money tight to fight inflation, because high inflation is Enemy No. 1 of long-term bonds. Thus, your hope now is that Fed Chairman Alan Greenspan, who wants to keep money tight, prevails over Treasury Secretary Nicholas Brady, who wants the Fed to ease, Gross says.

“A very loose Fed, as witnessed in the 1970s and 1960s, ultimately produces a lot of money and a lot of inflation down the road,” he says.

* Is a recession coming? Long-term bonds are generally one of the best investments in a recession--presuming it’s the usual type in which interest rates fall. Of course, accurately predicting a recession is the trick, and interest rates may not fall until several months into the downturn.

* Are those yields historically high? If bond yields rise to historically high levels, bonds may be poised for a rally. Yields in the 9% or 10% range are considered historically high, says Samuel (Spike) Thorne, managing director in charge of bond policy at Scudder, Stevens & Clark, a New York money management firm that offers mutual funds investing in zero-coupon Treasury notes and bonds. Thirty-year Treasuries now yield about 8.8%.

“In the history of the capital market, 9% or 10% is an awfully nice rate to hammer down,” Thorne says, adding that with the current inflation rate of about 5%, that translates into an inflation-adjusted real return of 4%. “That, in the history of this country, is an inordinately high real rate of return,” he says.

* Are stocks ready for a fall? If the stock market is setting new highs and everybody is euphoric, that might be the time to buy long-term bonds. Why? Because euphoric stock markets typically are followed by big falls or even crashes. When that happens, investors often move to Treasury bonds in a “flight to quality.”

For example, Benham Target Maturity Trust 2015, a mutual fund investing in long-term Treasury zeroes, gained about 25% in the week after the October, 1987, crash, says William E. Donoghue, publisher of Donoghue’s Moneyletter, a Holliston, Mass., newsletter. * Are bonds yielding a lot more than stocks? Low stock dividend yields (dividends per share as a percentage of stock prices) relative to bond yields could signal that bonds will outperform stocks.

The yield on the issues in the Standard & Poor’s 500 is now about 3.6%, providing slightly more than a five-percentage point differential against the 30-year Treasury bond. Some pundits say six points is a good spread signaling that money will move from stocks to bonds.

* Is Uncle Sam begging for funds? Watch big Treasury Department auctions of new bonds, such as last week’s, to determine whether investors are eager to snap up the issues, and at lower yields. If not, it could spell trouble.

But don’t overestimate the importance of auctions, Gross says, noting that the United States has become less dependent on the Japanese and other foreigners to buy our bonds. The slack, he says, has been picked up by Americans who are saving and investing more.

Also, Gross says, increased Treasury borrowing has been more than matched by diminished borrowing by private corporations and individuals because of the slowing economy. So total credit demand--from business and consumers as well as the government--may actually decline when government borrowing is rising, he says.

“Whenever the budget deficit increases because of cyclical considerations, such as slower economic growth, it’s an excellent time to be buying,” Gross says.

* Are foreign interest rates high and rising? When foreign interest rates are low--and falling--relative to those here, U.S. bonds may be a good investment. That’s because foreign investors, dissatisfied with low yields in their own countries, may shift money here.

Conversely, if rates overseas are relatively high, foreign bonds may be a good investment (depending also on whether the dollar is falling; a declining greenback increases the value of foreign securities).

Right now, foreign interest rates are relatively high and, in some cases, rising. Yields on German seven-year bonds (European governments tend to issue shorter-term bonds than does the U.S. Treasury) are approaching 8.8%, while Japan’s bellwether 10-year government bond rose above 8% this past week for the first time since 1983.