Many U.S. bond managers, encouraged by the prospect of a balanced federal budget and reduced government spending, are bullish on bonds for the next 12 months.
They say the domestic bond market, already benefiting from low inflation and a sluggish economy, could get a shot in the arm from government budget-cutters intent on reducing federal deficit spending.
The bond market is enjoying a major rebound this year. After dropping in value more than 22% in 1994, the 30-year government bond was up more than 24% through October. And, fixed-income indexes are solidly in double digits.
Now fixed-income managers and strategists are licking their chops at the prospect of congressional budget-cutting efforts,
As an added bonus to both bonds and stocks, Federal Reserve Board officials have said repeatedly that interest rates would be cut further if a meaningful deficit reduction package is passed by Congress.
Bond market experts almost unanimously yawn at the prospect that the government might have to shut down or, worse, default on its obligations.
"There is a surreal quality about the whole thing; it is so unthinkable that the U.S. would default, people just don't believe politicians from either party would be dumb enough to let something like that happen," said James Solloway, chief investment strategist at Argus Research Corp., New York.
Many bond market experts believe Congress will increase the debt ceiling, possibly in a series of continuing resolutions to extend the government's borrowing ability until a new budget is signed by the president.
Even if a short-term technical default occurs, bond professionals believe the results would be embarrassing and costly, but not catastrophic.
"The market does not expect a default of any kind. That is probably why the bond market is behaving itself so well for now. If there were a real fear the U.S. would not honor its commitments, the bond market would back up 50 to 100 basis points, or even more .*.*.," said Steven Gordon, director-fixed income at Warren D. Nadel & Co., Greenvale, N.Y.
It is the prospect of the government making a serious stab at cutting the budget deficit after years of lip service that is capturing the full attention of market watchers. President Clinton has expressed willingness to work with Republicans on a seven-year balanced budget plan if certain conditions are met.
"Clearly there is the hint of compromise. Our belief is that Congress will pass (a budget bill) which will be better than what we have now toward cutting the budget deficit," said Patricia Klink, president and chief investment officer of Advisers Capital Management Inc., New York.
The compromise budget bill, which by most estimates will include significant government spending cuts, "increases the probability that inflation will decline further or remain benign," she said. Her view is generally shared with few variations.
Frank Reilly, bond market specialist and professor of finance at the University of Notre Dame, South Bend, Ind., agreed conditions would be ripe for the bond market if significant budget cuts are enacted. He said it could get even better if the federal budget is brought into balance.
With a balanced federal budget, he said, there could be significant redistribution of investment assets away from government bonds and toward corporate bonds.
At current levels, that would mean a shift of about $40 billion each year from government bonds to other areas of the fixed-income markets.
Adrian Anderson, senior consultant with Wyatt Investment Consulting Inc., Atlanta, said Wyatt has been bullish on bonds since early this year; fiscal restraint in the form of deficit reduction and spending cuts adds to the allure of bonds, he noted.
The Treasury bond market stands to rally as a result of "meaningful" deficit reductions by the federal government, said Mr. Gordon at Warren Nadel. The laws of supply and demand indicate fewer government bonds would be coming to market and existing bonds would become more valuable, he said. He said Treasury bonds could rise 25 to 50 basis points initially based on a solid deficit reduction package.
Mr. Gordon said if inflation remains under control, long-term interest rates could then test the 1993 low of near 5.75%, which occurred just before the Federal Reserve Board started a series of interest rate boosts in 1994.
Ladell Graham, principal at Smith Graham & Co., Houston, is not convinced that a balanced budget or significant progress at reducing growth in government spending will set the stage for a strong bond market.
"I question whether a budget accord at this point will have a positive impact on the bond market," said Mr. Graham, "primarily because we have already had such a good bond rally this year. With rates so low, there is a question whether a budget accord would be positive for the bond market."
Mr. Graham agreed a compromise budget accord with significant cuts in spending "is meaningful," and if the bond market does rally because of the budget cuts, "it will be because of what's in the details of the plan and how the budget is implemented."
Ron Ryan, president of Ryan Labs Inc., New York, stopped short of claiming a deficit reduction package would create a long-term positive impact on the bond market.
He said a balanced budget still would not end the government's need to refund its debts. Currently, he said, most of each new Treasury issue is for refunding purposes and, consequently, does not go to pay off the debt.