The Virginian-Pilot
                            THE VIRGINIAN-PILOT  
              Copyright (c) 1994, Landmark Communications, Inc.

DATE: Sunday, December 18, 1994              TAG: 9412170142
                                             LENGTH: Long  :  149 lines


It was great while it lasted.

Lured by steadily falling interest rates, investors poured hundreds of billions of dollars into bonds and bond mutual funds between 1990 and late 1993.

In the process, they reaped some hefty profits.

But investors have been hemorrhaging those gains this year in a bond-market blood bath. Since January, bonds have lost an estimated $1 trillion of value. By some measures, the nation's bond market has suffered its worst year since the late 1920s.

And the carnage isn't over.

Among the losers are big securities firms, banks, bond mutual funds and individual investors. Even bankrupt Orange County, Calif., has blamed part of its financial woes on huge losses on bonds.

The sharp rise in interest rates this year, along with mistaken bets on their direction, precipitated many of the losses.

In an effort to slow the nation's economic expansion, the Federal Reserve has been boosting short-term interest rates, which reduces the value of existing bonds and fixed-income investments.

Given the continued strength of business activity, many economists and analysts expect the Fed to continue raising short-term rates. So far this year, the Fed's Open Market Committee has hiked short-term rates six times, and the committee is scheduled to meet again Tuesday.

How bad have investors' losses in the bond market been in the wake of the Fed's action?

As bad as the $1 trillion paper loss that investors suffered in the stock market crash of October 1987, the Securities Industry Association declared in a report earlier this month.

``From January to mid-November, we estimate that fixed-income instruments have also lost $1 trillion in market value,'' the association of brokerage firms and investment bankers said.

The association figured that losses on Treasury securities accounted for half of the $1 trillion in bond losses. The reduced values of corporate bonds generated another $300 billion of losses, while municipal bonds accounted for $200 billion of losses.

With $9 trillion of bonds outstanding at midyear, the bond market is almost twice the size of the stock market.

But activity in the sprawling arena that includes corporate bonds, state and municipal bonds, Treasury securities and mortgage-backed securities, rarely attracts the attention that the stock market does.

If stock prices had dropped to the extent that Treasury bond prices have fallen this year, ``everybody would be in a state of panic,'' said Douglas Bretz, manager of the retail fixed-income department at Wheat First Butcher Singer, a Richmond-based brokerage firm.

In a market where interest-rate changes are usually measured in 100ths of a percentage point, the increase of 2.5 percentage points in the yields of 30-year Treasury bonds this year has been jolting. So has the 20 percent plunge in the prices of these bonds.

For those individuals who abandoned bank certificates of deposit for the higher yields available from bonds and bond mutual funds, that loss of value has been a painful lesson in interest-rate risk.

Treasury bonds are considered some of the safest investments available because the risk of default by the federal government is negligible. But even mutual funds that invest only in Treasury securities have been badly bruised this year from soaring rates.

``A lot of people looked at (Treasury bonds) and misinterpreted their lack of credit risk for a lack of market risk,'' said David Orr, chief economist for the Charlotte-based bank holding company First Union Corp.

For anyone investing in long-term bonds, including Treasury bonds, this year ``has been an unmitigated disaster,'' he said.

The disaster has not been been limited to individuals accustomed to putting their money in bank CDs. More sophisticated investors, including commercial banks and bond dealers, also have suffered losses.

On Wall Street, a handful of large brokerage firms, including the parent of trading giant Salomon Brothers, have admitted to heavy losses stemming from their bond trading.

In Virginia, Central Fidelity Banks Inc. said its pretax profits for the Dec. 31 quarter will be reduced by $30 million because of a restructuring of its investment portfolio, which consists of Treasury and other government securities. The Richmond-based banking company said it was in the process of selling off $500 million of these lower-yielding securities.

Although Central Fidelity had expected some increase in interest rates this year, ``we didn't think the Federal Reserve would raise them this far this fast,'' Charles W. Tysinger, the company's treasurer, said when the earnings news was announced.

When interest rates are rising, investors who hold their bonds until they mature forgo the opportunity to reinvest at a higher yield. However, they do not suffer a loss of principal on those bonds.

That's not the case with bond mutual funds. When interest rates climb, shareholders in bond funds can suffer a loss of principal because the funds do not have a maturity date like individual bonds do.

After doubling in asset size in less than four years, the nation's bond and income mutual funds suffered a net outflow of $34.5 billion outflow between March and October this year, according to figures compiled by the Investment Company Institute, a mutual-fund trade association.

By the end of November, the combined assets of bond and income funds had tumbled to $710.8 billion from a peak of $780.1 billion in January, according to the association.

Some of the investors disheartened with bond funds have shifted their money back into bank CDs. Others have put their money into money market mutual funds, which buy short-term financial instruments like commercial paper and Treasury bills.

Banks, which often have a variety of funding sources, have not been competing aggressively for fresh deposits, and their rates on CDs have failed to match Treasury-bill yields on Treasury bills or the rates paid by money market mutual funds. One reason is that many banks still have large portfolios of investment securities that they can tap when making new loans, said First Union's Orr.

Given the Federal Reserve's determination to curb inflation, short-term interest rates probably will continue climbing, economists and analysts predict. And that could prolong the exodus out of bond mutual funds.

What are the chances that the Fed's Open Market Committee will again boost rates when it meets Tuesday?

``It's a tough call, but I think they'll pass'' this time, Orr said.

Under ordinary conditions, the committee probably would raise rates by a half percentage point, he said. But a half-point increase could add to the uncertainty in the financial markets caused by the bankruptcy filing of Orange County, Calif., Orr added.

Before seeking court protection from its creditors, the affluent county blamed its financial straits on $1.5 billion of bond-related losses in a county investment fund.

If the Fed's Open Market Committee decides not to raise interest rates this week, it will likely boost rates at its next meeting in late January, Orr predicted.

Amid the bond market's gloom, some investors see indications of a brighter future. In recent weeks, the yields on 30-year Treasury bonds have declined, evidence of greater demand for the long-term securities.

After spending most of 1994 sitting on the sidelines and holding cash, Paul M. Montgomery began buying a mix of long-term bonds, including Treasury bonds, municipal bonds and zero-coupon bonds, last month.

The Newport News money manager and bond-market specialist said he pulled out of the market in October 1993 partly because banks and other investors developed a voracious appetite for fixed-income securities last year after rates had already fallen dramatically.

But by mid-November, the yields on some types of long-term bonds began to look increasingly attractive, and Montgomery committed half the money he manages to bonds. ``I've been bullish for three weeks now,'' he said.

Still, Montgomery acknowledged that 1994 proved to be a difficult year for anyone investing in bonds. ``It's been grim. Even the best and the brightest have been hammered.'' ILLUSTRATION: Graphic


SOURCE: Lehman Brothers

[For complete graphic, please see microfilm]

by CNB