The fear of inflation has sent many bond managers scattering for shelter for the remainder of 1994, shortening portfolio durations and seeking relative safety in the short- to intermediate-term sectors.
And while there is little expectation for a bond market rally soon, some bond specialists believe the worst might be over for a market hammered by five interest rate increases since February, a weak dollar and the real or perceived threat of inflation.
But most also expect further Fed tightening this year and early next year to slow the economy and to prevent inflation from gaining momentum. They do not expect tranquility to return to the bond market before mid-1995.
The feeling among bond experts is that interest rates will continue to trend upward for the balance of 1994.
Bond investors worry most about inflation, which cuts into the value of fixed-income securities.
Last week's announcement that wholesale prices increased by a higher-than-expected 0.6% fueled inflationary fears even more in a market already running scared - even though the increase was partially offset by a lower-than-expected increase (0.3%) in the Consumer Price Index.
"People are concerned about inflation, and we believe it could be even higher than the market expectations of 3% currently," said Ladell Graham, chief investment officer at Smith, Graham & Co., Houston, which has $1.3 billion in fixed-income assets under management.
"We see various consumer price components increasing somewhat over the next 12 months," Mr. Graham said. He said the increases in the CPI and producer prices, along with the talk of rising inflation, are "not good news" for the bond market. Such talk "creates uncertainty in the market, and the market doesn't like uncertainty. It also causes rates to rise and bond prices to decline. We are concerned about inflation, yes, but we are not necessarily worried," Mr. Graham said.
Bond managers and investment strategists generally agree fixed-income investors must be positioned strategically along the yield curve to avoid further pain if the Federal Reserve Board tightens again this year.
Broad market returns, as measured by the Salomon Broad Investment Grade Index, were negative for the three consecutive quarters ended June 30 - the first time since 1979-1980.
Most bond experts believe the market remains hostage to Federal Reserve Chairman Alan Greenspan, who engineered rate increases from a low of 5.77% on the 30-year Treasury bond in October of last year to the 7.7% range now. And, the economy and inflation notwithstanding, as interest rates go, so goes the bond market.
"The Fed has more wood to chop," said Fred Quirsfeld, vice president and senior portfolio manager for fixed income at IDS Institutional Retirement Services, Minneapolis. "We don't think we have seen the last of the rate increases. That being the case, we don't see any possibility of a sustainable rally in the long-term fixed-income market."
IDS expects the Fed to raise rates once more this year and again in early 1995, he said, which should squelch inflation to 3% or lower and bring long bonds down to the 7% range.
IDS shortened the duration on its $4.5 billion bond portfolios to an average of 5.5 years, in line with the duration of the Lehman Aggregate and the Lehman Brothers Government/Corporate Bond Index.
"In 1995 there will be more opportunities to make interest rate bets and extend durations," Mr. Quirsfeld said. But for the remainder of 1994, "we will be in a neutral mode since there are not a lot of opportunities in the market to make money on interest rate bets. ... We are keeping our powder dry until the Fed finishes."
IDS expects the bellwether 30-year Treasury bond to trade in the 7.25% to 7.75% range for the balance of 1994, while Patricia Klink, president and chief investment officer of Advisers Capital Management Inc., New York, sees the upper end of the trading range at closer to 7.9%.
Ms. Klink said until inflation fears are eliminated, she does not look for a bond market rally.
"There seem to be great questions whether the economy is going to slow (in the wake of the Fed tightening). Economic forecasters are going to start revising their economic growth predictions upward now, and that's going to be another negative for the bond market," she said.
Inflation is going to be a problem, she said, "and we believe we are starting to see the first numbers which demonstrate that," referring to last week's wholesale and CPI numbers.
"We would not be surprised to see more inflation statistics over the next few months," she said. "No one believes the Fed is finished (tightening). Most expect further tightening, and we would agree. The Fed clearly wants to be ahead of the price curve ... in order to prevent demand and supply pressure from turning into serious cost-push pressure, or real inflation, where people begin anticipating inflation and start raising prices. But we don't see that type of pressure developing.
"But the economy is still growing rapidly enough that the Fed continues to feel more tightening is needed to prevent real inflation from developing," she said.
She expects the Fed to push rates higher again before the end of 1994 and again early in 1995.
"We don't expect to see the market realization that long-term inflation isn't rising until next year. Therefore we can't predict that we are imminently going to see improvement in the long end of the market."
Meanwhile, she said, investors will be doing well to earn the coupon rate on bonds for the balance of 1994. She said Advisers Capital will seek active total return maximization by holding high-quality, liquid obligations and low-volatility mortgage-backed securities.
To increase incremental returns, she said her firm looks for mispricings that may occur "between Fed tightenings."
Ms. Klink said the magnitude of the rise in rates since October is unlikely to happen again. Still, she said, the bond market can expect "continued misery" for the next few months.
"Slow torture is often worse than a quick slice. Have we seen the end of the bear market? We simply don't have an answer to that question."
Brown Brothers Harriman & Co., New York, with more than $22 billion under management, expects intermediate and long-term rates to decline in coming months and has begun targeting longer durations in its portfolios, according to Jeff Schoenfeld, senior manager in the fixed-income group.
"Our premise is that we expect the economy to slow to the 2% to 3% range in the second half of 1994 (following a nearly 3.5% rate in the first half). That is significant because growth under 3% will allow the Fed to maintain rates where they are currently," said Mr. Schoenfeld.
But, he said, the bond market fully expects another 75 basis-point increase in the Fed funds rate by the end of 1994 and another 50 basis-point increase in the first half of 1995.
"That seems extreme and would appear to be too bearish an outlook in our opinion. We believe there is a good chance the Fed funds rate will remain where it is through the end of the year, predicated on a slowing economy and growth at a moderate pace. We look for rates to be down a bit for the remainder of this year in the two- to 30-year range. The long bond could be at 7% by the end of the year," he said.
Mr. Schoenfeld said there are opportunities in the intermediate and long-term markets in certain sectors. He said asset-backed securities such as adjustable-rate mortgages "remain attractive." In addition, he said, some high-quality corporate bonds will look good as profits continue to increase and the economy grows at a moderate pace. Brown Brothers also expects municipal bonds "on a selective basis" to perform well.
Collateralized mortgage obligations are not favored now, he said. "The CMO market is so illiquid right now, some time needs to pass and liquidity needs to return before we go into CMOs."
Mr. Graham, at Smith, Graham, said he believes the Fed may not have finished tightening and sees rates trending slightly upward.
" If we continue to see higher inflation, I'd expect the Fed to continue tightening; there could be another 50 basis-point increase by year end as long as inflation continues to trend up. We see long bond rates going probably to the 7.25% to 8% range. The good news is that we don't expect a repeat of what has happened during the last six months," he said.
With long rates trending upward, he said, "portfolios positioned at the shorter end of the market with the Merrill Lynch 1- to 3-year Index will perform well on a relative basis. Preservation of capital is where the best value on a total return basis will be in the next year or so."
While most bond market specialists are expecting increases in interest rates, there are some who predict lower rates and better times in the bond market.
Frank Reilly, professor of finance at Notre Dame University and a bond market researcher, said it is almost inconceivable to believe 30-year U.S. Treasury bonds will reach 8% or 9% soon. He said a move to 8% on the long bond "is such a small possibility I wouldn't be concerned with it."
Mr. Reilly said the "bloodbath" in the bond market is essentially over, and fixed-income investors may face volatile markets in coming months but still can make money "depending on where you are on the yield curve."
"If you are in the short end of the curve, one or two years, you may not do as well. But there is some upside potential in the long end in coming months. At the current level of about 7.5% on the long bond, that really anticipates a fair amount of inflation built in and, if that is correct, we could see rates coming down to near the 7% level," he said.
