Pause in the Bond Boom

Inflation fears could snuff the investment rush to fixed-income securities

When it comes to making big money quickly, thoughts of investing in bonds have not traditionally leaped to mind. Then came the summer of 1982, when declining interest rates gave the nation's $2.3 trillion bond market a spectacular liftoff, making born-again believers out of a generation of battered bondholders.

Though the stock market rally was better publicized, overall returns, counting capital gains as well as interest, made the 1982 surge in everything from US Treasury securities and corporate bonds to municipal bonds sold by state and local governments equally impressive. Investors racked up gains that approached 35% for ultrasafe investments in U. S. Treasury bonds and notes, with the rise in corporate and municipal bonds not far behind. The generous returns result when interest rates drop because bonds issued earlier at higher rates automatically become more valuable and shoot up in price.

For businessmen as well, the surge was gratifying. In recent years they have been borrowing heavily on a short-term basis to finance long-term projects a practice that Henry Kaufman, the celebrated credit market analyst at the New York investment banking firm of Salomon Brothers Inc., describes as "a little like trying to finance the building of one's house with short-term loans." Since the cost of most of that money has floated with the fluctuations in short-term interest rates, businesses have found investment costs hard to estimate in advance and have got burned as rates soared Now that long-term rates are at last dropping Kaufman predicts that corporations will sell a record $65 billion in bonds next year, up from $40 billion this year.

Yet hardly had 1982's bond market bulls had a chance to tot up their winnings when much of the euphoria that accompanied the rise in bond prices began to fade. Prices have begun to weaken ever so slightly, and interest rates have started to nudge upward. Reason: fear is spreading that inflation, a mortal menace for all fixed-income investments, could resume with a vengeance if the economy comes out of its doldrums. Says Raymond Dalio president of Bridgewater Associates Inc., a Connecticut-based economic and investment consulting firm that was strongly bullish on bonds last winter and spring but is much more cautious in outlook now We think there is perhaps some rise still to go for bond prices. But the big gains are over."

For the nation's weak and troubled economy, the bond market's sudden jitters could not have come at a worse time Interest rates have dropped dramatically since last summer, when even the highest grade corporate bonds yielded close to 14%. But triple-A corporate bond yields still hover above 11%, and lower rated issues provide yields substantially higher Those are levels that many economists feel are far too high for sustained economic recovery.

In fact, so-called real interest rates which reflect the cost of borrowing minus inflation, have actually increased slightly during the period because inflation has fallen faster than interest rates. Says C. Fred Bergsten, director of the Washington-based Institute for International Economics: "Interest rates must drop by two more points. It is critical for the U.S. and world recovery."