Why a Few Pundits Favor Long-Term Bonds

Dismally low short-term interest rates are likely to spark another stampede into long-term bonds soon.

And new investors will probably wind up chasing the same kinds of bonds that millions of others have sought in recent years: Securities that mature at least three years away but not much more than seven years away.

Nobody, it seems, wants to own truly long-term bonds of 10- to 30-year maturities--even though they offer the highest yields in the market and some of the highest yields in history compared to short-term rates.

Nobody perhaps except William Gross of Pacific Investment Management Co., a Newport Beach-based money manager that runs $36 billion for clients nationwide.

One of the country’s most respected bond market players, Gross has for six months been pounding the table for longer-term bonds.

He still is--at a time when most bond managers maintain that sinking money into such securities is borderline insanity.

In fairness to the majority, the conventional (i.e., non-Gross) wisdom about bonds appears reasonable, at least on the surface. It goes like this:

* Interest rates have slumped dramatically since 1987, but with the economy more or less reviving we’re nearing the end of the line for rate cuts. The Federal Reserve’s half-point cut in short-term rates on July 2 was the final swing of its machete.

* While longer-term bond yields could slide a little further in coming months, both short and long rates will begin rising again by late fall, assuming that the economy stays afloat and people and businesses begin borrowing again.

So if you want to earn more than a paltry 3% at the bank, many pros say, buy a five-year Treasury note yielding 5.91% currently. It’s double the bank return, and even if market interest rates begin to rise over the next few years, a 5.91% annual yield is a decent return to be stuck with until the note matures in 1997.

What about a 10-year Treasury note now yielding 6.93%--a full point more each year than the five-year T-note? Not worth the risk, most bond pros will tell you. Ten years is way too long to lock up your money, because who knows what will happen in the interim?

That kind of skittishness about going beyond so-called intermediate-term bonds has dominated Wall Street in recent years, and Pacific’s Gross agrees that that attitude has been logical, given the economic and interest rate uncertainty.

Staying in intermediate-term bonds has in fact worked beautifully since 1989. As the accompanying chart shows, returns on bond mutual funds that own intermediate-term securities--whether Treasury, corporate or municipal--have beaten or run very close to returns on funds that own longer-term securities. So there has been little incentive to favor longer-term bonds.

But could so many people love the intermediate-term story that they’re loving it to death? Gross believes that it’s time for long-term bonds to outshine intermediate-term issues, and he states his case like so:

* The mushrooming demand for intermediate securities now has pulled their yields down to levels that no longer make them attractive--not, at least, when you can get much better yields farther out, Gross says.

While the yield on five-year Treasury notes has slumped 1.30 points since last August, from 7.21% then to 5.91% today, the 10-year T-note yield is down just 0.85 point since then, from 7.78% to 6.93%. Simple math, says Gross, tells you that “longer-term bonds have a lot more value relative to inflation” (now running at 2% to 3%) than intermediate-term issues.

* When yields on foreign long-term bonds finally begin to come down--most likely later this year--they’ll pull long-term U.S. yields down as well.

A global investor hunting for a 10-year government bond can pick up a yield near 8% on German issues, Gross notes, because the German central bank has been keeping rates high to choke off inflation there. That has kept upward pressure on long-term yields here.

But slowing foreign economies foreshadow lower interest rates abroad, Gross says, and that should help long-term U.S. yields most.

What about the widespread expectation that the Federal Reserve will be forced to raise interest rates soon after the election, assuming a recovering economy? Gross doesn’t buy it, citing the slow pace of the recovery and the lack of inflation. “I think those long-term secular forces are working against the Fed coming and tightening anytime soon,” he says.

Yet if and when that happens, Gross finds still another reason why long-term bonds will look better than intermediate-term issues: The shock is likely to be that the greatest damage will be to intermediate-term bonds, not to longer-term bonds, he says.

Most bond investors understand that when market interest rates go up, the value of their older bonds goes down. After all, a $1,000 bond that pays a 6% yield obviously can’t still be worth $1,000 if new bonds are paying 7%.

But if a bond matures in only a few years, its principal value shouldn’t be drastically affected by changing market interest rates, because the owner knows he or she isn’t stuck with a sub-par return forever.

Therein is a big part of the recent attraction in intermediate-term bonds.

That’s all well and good, Gross says. But he believes that the problem the intermediate sector will face if rates begin to rise is simply that so many investors now are in that part of the bond market. Many instinctively will try to bail out, to go back to cash investments. The analogy of a theater crowd rushing for a single fire door comes to mind.

By Pacific Investment’s calculations, 55% of all U.S. Treasury debt now is in the one- to 10-year maturity range, while only 20% is in 10-year-or-longer maturities.

Of investment-grade corporate bond debt, 59% is in the one- to 10-year range, while 40% is longer term.

Judging the intermediate-term sector’s performance just on history alone, Gross says, when the interest-rate cycle turns, “intermediate-term bonds tend to go up much more in yield and act much more like long-term bonds” than investors are led to believe in advance.

Worse, this time around if bond yields snap back, they have much more ground to retrace in the intermediate-term sector than the long-term end, Gross notes, because the former have dropped so much more sharply than the latter.

Gross isn’t suggesting that small investors sink every penny they own into long-term bonds, anymore than Pacific Investment would do that with its entire $36-billion stash.

But if you don’t have some piece of your bond portfolio in the long-term end today, he says, you’re ignoring the income investment that should provide the best returns in a slow-growth, low-inflation economy. If most people don’t recognize that yet, it wouldn’t be the first time the crowd was wrong.

Bond Funds: Short, Long, In-Between

Bond mutual fund investors today can choose not only the type of bonds they want to own, but also the maturities--short (bonds typically maturing within a few years); intermediate (five to 10 years); or long (10 years or more). Here are historical results for various categories as measured by average total returns, which include the interest yield earned on the bonds plus or minus the net change in the bonds’ principal value in the period.

Average total investment returns: Bond fund category 1989 1990 1991 1st half-’92 Corporate, short-term +9.97% +8.09% +11.90% +2.83% Corporate, intermediate-term +11.13% +7.20% +15.23% +2.62% Corporate, long-term +12.53% +6.78% +16.38% +2.40% U.S. govt., short-term +10.25% +9.01% +11.60% +2.42% U.S. govt., intermediate-term +11.74% +8.51% +14.50% +2.06% U.S. govt., long-term +12.87% +7.38% +14.47% +1.79% Municipal, short-term +7.01% +6.39% +8.15% +3.04% Municipal, intermediate-term +8.07% +6.58% +10.42% +3.43% Municipal, long-term +9.51% +6.01% +11.91% +4.29% World, short-term NA +18.33% +7.37% +3.27% World, long-term NA +12.42% +14.11% +2.19%

Source: Lipper Analytical Services

Tracking Yields

How yields now stack up on U.S. Treasury securities of varying maturities:

Term Fri. Yield 3-month 3.28% 6-month 3.38% 1-year 3.59% 2-year 4.35% 3-year 4.86% 5-year 5.91% 7-year 6.44% 10-year 6.93% 30-year 7.64%