US Bond Yields: Less Sparkling in '92

EVERYONE'S talking about the stock market, given its bullish course since the Federal Reserve Board slashed the discount rate by a full percentage point in late December. But there's another relatively happy camper in the investment world: the bond market.

Bonds enjoyed a surprisingly good year during 1991, with more than $60 billion of new money pouring into bond mutual funds alone; overall, many funds posted returns of 14 percent or better, with the average taxable bond fund climbing 18 percent. Measured by total return, bonds enjoyed their best year since 1986. And US corporations are currently scrambling to sell new bonds to take advantage of low borrowing costs.

Barring the unexpected, the bond market should do well again in 1992, say experts such as Stephen Smith, the chief investment officer who coordinates fixed-income strategy for Brandywine Asset Management Inc. in Wilmington, Del. Whether the bond market can beat last year's impressive numbers, however, remains open to question, says Mr. Smith; he predicts 1992 "will be good, but a slightly tougher year" for bonds, with lower returns.

Smith is not alone. Many analysts believe returns approaching 10 to 12 percent will characterize many bond funds this year.

In the spring of 1991 Smith set up a fixed-income program for Brandywine, after arriving there from Mitchell, Hutchins Asset Management Inc., the investment and advisory arm of PaineWebber Inc. When Smith first started at Brandywine, the firm was entirely an equities management shop - holding no bonds. Now, Smith manages two fixed-income pension-fund accounts for Brandywine with total assets exceeding $34 million. Starting from scratch, his two bond accounts were up 23 percent last year; impressive, he n otes - but a very tough act to follow for '92.

Smith says the current economic conditions, particularly the persistence of low inflation, should continue to provide high real returns on bonds. He thinks inflation will stay below 3 percent this year, a position that runs contrary to some economists who fret that with continuing interest-rate cuts by the Fed, the economy may get so heated later in '92 that there will be a resurgence of price pressures. But commodity prices are low, Smith notes, which helps reduce production costs. Wage pressures have b een under control, because of the large numbers of layoffs in corporate America. If there is any real threat to the economy, argues Smith, it stems from the drag of huge tax burdens at the federal and local levels, which divert disposable income away from productive investment or retail consumption.

Nonetheless, Smith is neither pessimistic about the overall economy nor the bond market, although he encourages fixed-income investors to keep their expectations somewhat modest this year. In setting up his bond program at Brandywine, Smith said that the firm wanted him "to look at bonds globally, and not just in domestic [US] terms." Thus, he designed a program where 35 percent of assets could be in foreign bonds. (Yields are running higher on many foreign issues than for US bonds.) Currently, 25 percen t of his assets are in intermediate financial paper; 28 percent in foreign bonds; 30 percent in a 30-year Treasury bond, and the rest in noncallable US corporate bonds.

Most of his foreign bonds are from Canada, New Zealand, and Japan, although about 2 percent are from Germany. All of the overseas bonds are government issues.

Smith says part of the public gloom in the current downturn has stemmed from shoddy reporting. Unemployment "is well under what it was" in recent recessions. Occasional comparisons with the late 1920s are way out of line, he says, pointing out that from 1929 to 1933 the money supply in the US contracted by roughly 25 percent as a result of belt-tightening by the Fed. During the past three months alone, he notes, M1, one of the main measurements of money supply, has expanded 11 percent.

Smith expects the rate differential between foreign and US bonds to gradually converge during the decade.