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Trading Instead of Holding
Has Often Failed in Bond Rally

By GREGORY ZUCKERMAN
Staff Reporter of THE WALL STREET JOURNAL

Bonds are beautiful.

At least that's what you'll hear from Stuart Cole, a California ophthalmologist who is up to his eyeballs in them. He missed much of the 1990s stock-market surge by putting almost 60% of his assets in bonds. But now, on the heels of an eight-month rally, he is ready to take some credit. "I feel rewarded for my devotion to bonds," Dr. Cole says.

But don't talk to William Kirby about big bond profits. He is co-head of bond trading at Prudential Securities, where he buys and sells the debt securities on a daily basis. "It's been a difficult trading environment," Mr. Kirby says. "I don't care who you are, you've had some tough days."

The 1997 bond rally reached a milestone Thursday as the 30-year Treasury's yield, which moves in the opposite direction from its price, went below 6%. In late-day trading, the yield was 5.99%.

As recently as April 11, the yield on the "long bond" was nearly 7.2%. That means someone who bought such a bond then and still owns it would now have a total return, which includes both interest and capital appreciation, of more than 20%. Treasurys have outperformed stocks since midyear.

But this robust rally has been a largely unexpected one, fueled by a rare economic environment. The rally's surprising power -- along with the stop-and-start way it has proceeded -- has left many Wall Street bond professionals flummoxed, often profiting far less than the individual, buy 'em and hold 'em investor.

Tame Inflation

The extraordinary background includes a steadily growing economy, expanding corporate profits, increasing hourly wages and historically low unemployment -- yet profoundly subdued inflation. Inflation -- anathema to bond buyers because it erodes the value of fixed-income payments -- is running at an annual rate of only about 2%, as measured by the Consumer Price Index.

Even though employees' pay is rising, so is their productivity, which eases fears that a tight labor market and higher labor costs will reignite inflation. Indeed, proponents of what is called the New Paradigm theory of economic growth argue that the combination of technological advances, global competition and productivity improvements will keep price pressures at a minimum, and bonds popular, far into the future.

Another bond boost comes from the rapid shrinkage of U.S. budget deficits. This reduces the government's need to borrow and thus holds down the supply of bonds, pushing their prices upward.

At the same time as tame inflation makes investors feel comfortable owning bonds, other things drive them to do so.

The currency and stock-market turmoil that began in Southeast Asia and spread elsewhere has sent many investors, both American and foreign, rushing to the haven of super-safe U.S. government debt. Strength in the dollar, which makes U.S. securities more valuable to investors abroad, has added urgency to this flight to quality. And as gold loses its appeal as a sanctuary for wary investors, some gold bugs are scurrying into Treasurys.

All this has produced big paper returns for long-term investors such as Dr. Cole. He and other individual investors often hang on to bonds until they mature. But if these investors choose, they now have the option of selling out for hefty capital gains.

Few bond pros hold for very long. Wall Street traders, mutual funds and hedge funds -- private investment partnerships -- buy and sell, trying to maximize their returns. And those pros who do hang on to their bonds generally buy riskier, lower-rated ones. Neither of these approaches -- trading a lot and buying riskier bonds -- has worked well lately.

Active traders are gnashing their teeth -- because the rally has caught many off guard. Economists and strategists at firms ranging from Lehman Brothers Inc. to Merrill Lynch & Co. to Goldman, Sachs & Co. -- hallowed names in the bond world -- all failed to anticipate how sharply yields would drop and prices rise.

Of 39 Wall Street economists polled by The Wall Street Journal in July, not one predicted that long-term rates would be below 6.2% by the end of this year. Just 18% of bond mutual funds have beaten the benchmark Lehman Brothers bond index this year, according to Morningstar Inc., the Chicago firm that tracks such things. The index, which encompasses a wide variety of bonds and includes both their interest payments and their capital gains or losses, is up 8.59% for the year to date.

Bond traders, many of whom rely on gradual, defined trends to make money, certainly have had their work cut out for them. Despite the 1997 rally, bond powerhouse Salomon Brothers saw its revenue from fixed-income sales and trading fall 11.5% in 1997's first nine months, compared with a year earlier. (Salomon is now part of the Salomon Smith Barney unit of Travelers Group Inc.) Other firms don't break out their bond-trading performance, but traders up and down Wall Street say many have been sideswiped by bonds' unrelenting gains.

"Wall Street has had a tough time with the moves in the market because yields have come down even as the economy grows very strongly, which doesn't usually happen," says John Youngdahl, Goldman Sachs's money-market economist.

Those Wall Street players who do hold their bonds have also generally underperformed Main Street, because most have drifted away from Treasury and top-grade corporate bonds and toward such securities as junk and emerging-market bonds. But Treasurys have turned out to be the best bet lately. When the emerging markets overseas crumbled, sparked by Asian currency problems, many bond professionals were saddled with huge losses. Junk bonds, too, have suffered from investors' instinct to seek a sanctuary.

Last month, Chase Manhattan Bank acknowledged losing $160 million in a sell-off in emerging-market bonds. Other big banks, hedge funds and mutual funds also are believed to have suffered sizable losses in these bonds.

In recent months, the Merrill Lynch World Income Fund shifted a large chunk of its portfolio away from more established bond markets and into such markets as Venezuela, Argentina and Russia. Setbacks there have helped keep the mutual fund's return for the year to date at a relatively weak 5.3%, according to Morningstar.

Of course, some bond pros did play this rally right. One way was by concentrating on longer-maturity bonds, which have risen more than shorter-term ones. The American Century Benham Target 2020 Fund sports a return of almost 24% for the year to date. It owes that performance to a strategy of buying zero-coupon bonds with an average maturity of 23 years. Zero coupons, which pay no interest but make a payment of principal and interest at maturity, are volatile, moving in wide swings in reaction to a shifting interest-rate environment. So the Target 2020 fund has done well both because its bonds were zeros and because they had relatively long maturities.

But a lot of the smart money has made dumb moves. Another example: To protect themselves against possible losses in emerging-market bonds, many Wall Street pros borrowed Treasurys and sold them. The idea was that if emerging-market bonds crumbled, so would Treasurys, and the traders would at least profit on the short sales. But when emerging-market bonds did sink, Treasurys rose, because of the "safe-haven" factor. So the traders lost both ways.

"These are unprecedented times that have been very challenging for Wall Street," says William Lloyd, head of market strategy and credit research at Barclays Bank PLC's Barclays Capital unit.

The pros still can't agree on what the market is up to. There are about as many analysts who argue that interest rates will next be raised -- to head off any comeback by inflation -- as there are experts who predict the Fed's next move will be to cut rates -- to keep growth on track if Asia's problems curb the economy.

Two Sides

Often these starkly divergent views arise within a single firm. Barton Biggs, chief global strategist at Morgan Stanley, Dean Witter, Discover & Co., foresees a "global bull market for bonds"; but Stephen Roach, Morgan Stanley's chief economist, anticipates severe bond losses and expects the long-bond yield to rise to between 7% and 7 1/2 % sometime in the first half of 1998. "It's been a friendly and healthy debate," Mr. Roach says.

"There's a battle about the New Paradigm, even within firms," notes William Gross, a prominent bond expert at Pacific Investment Management Co. in Newport Beach, Calif. "The market's unconvinced one way or the other and is reacting in violent fashion."

Even Federal Reserve Chairman Alan Greenspan seems puzzled, alternately appearing to dismiss or to endorse the New Paradigm theory. "This is about the fifth time in the past three years that the Fed chairman has confused the markets with his new-era vs. old-era mood swings," quips Edward Yardeni, chief economist at Deutsche Morgan Grenfell Inc.

Partly because of this uncertainty among bond buyers, this year has already produced more major moves in Treasurys than any since 1994, according to Kiewit Investment Management in Omaha, Neb. Some nimble market makers have been able to prosper from the volatility by widening the difference between the bid and offered prices they quote. But until recently, most have been unable to capitalize consistently because it has been a stop-and-go rally.

"Volatility is good for the Street, but this has been excessive; the trend hasn't been your friend," says Mr. Kirby, the trader at Prudential Securities, a unit of Prudential Insurance Co. of America. "You're liable to be run over by the herd."

Buying Bond Funds

Individual investors, content to sit on their bonds, share little of this unease. And they have really been warming to bonds in 1997. This year through October has seen a $12.48 billion net inflow into bond mutual funds, according to the Investment Company Institute. That follows 1995 and 1996 net outflows totaling $8.27 billion.

Several investment firms, among them Charles Schwab & Co., T. Rowe Price & Associates and Vanguard Group, find the individual investors they deal with showing more interest in buying bonds. In October, for the first month in four years, investors put in more money than they withdrew from government-bond funds.

Are they making the right move? Could be. The current consensus is that if inflation remains in check, the yield on the benchmark 30-year Treasury bond will stay near 6% and could even approach October 1993's 5.78% yield, which was the lowest since 30-year government bonds were reintroduced in 1977.

Some economists see U.S. inflation easing to a meager 1.5% rate next year. If it does, and if a new era of improved productivity has indeed dawned, bonds should continue to do well.

Meanwhile, bonds make up a smaller percentage of institutional investors' portfolios than ever before, according to Ned Davis Research in Venice, Fla. This suggests that any portfolio re-allocation would find institutions buying more bonds -- and putting upward pressure on their prices.

"The case for U.S. government obligations as the best paper in the world has seldom been stronger," Morgan Stanley's Mr. Biggs contends.

If Treasurys do stay strong, the economy and many corporations will benefit, too. The bond rally has enabled those who issue new bonds -- companies as well as the government -- to lock in low rates, saving lots of money. Many economists say lower borrowing costs are a key reason profits have remained robust and home buying at record levels.

Best Case

Still, there is a limit to how well Treasurys can do. Interest rates don't go below zero. Even a best-case scenario for bonds is about a 5% yield on the 30-year Treasury by the end of next year. For people buying now, that would produce about a 20% total return -- wonderful, in view of the modest risk, but still not what stocks can produce in their best years.

"Bonds might be stuck until there's hope of the Fed lowering rates," warns Jim Bianco of Arbor Research & Trading in Barrington, Ill. "And if they don't, those getting in now will get burned."

Because the particular blend of bullish elements currently supporting the Treasury market is unique, it is difficult to predict how long it will hold together. As impressive as the fundamentals now seem, many -- such as deficit reduction and inflation -- can't get much better. And some could worsen.

When Mr. Greenspan last month called the economy's productivity improvement "a once-or-twice-in-a-century phenomenon," he underscored the concern of bond players that some market underpinnings for the rally could prove temporary.

In addition, a calming of the global market turmoil could reduce investors' appetite for safe-haven Treasury bonds. Stock and corporate-bond buyers could return to their first loves, undermining demand for Treasurys.

While these risks keep bond traders on the edge of their seats, investors like Dr. Cole, who is in Palos Verdes, Calif., remain unfazed.

"I don't buy and trade like Wall Street," Dr. Cole says. "I'll continue to buy bonds, put them away and do well in the long term." The return, he adds, "is more than satisfactory, and permits me to sleep better at night."