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No simple equation between rising deficit, bond rates

By HELEN HUNTLEY, Times Staff Writer

© St. Petersburg Times
published February 23, 2003


With tax cuts on the president's agenda and war looming on the horizon, it looks as though the federal government soon will be borrowing more money to finance big budget deficits.

Does that mean higher interest rates ahead?

Probably. When there is a gap between tax collections and spending, the government makes up the difference by borrowing money -- selling U.S. Treasury securities and savings bonds to investors.

All other things being equal, more borrowing should lead to higher rates just on the basis of the old economic law of supply and demand. If investor demand is constant and the supply of bonds goes up, you'd expect the government -- and other borrowers, including corporate issuers of bonds -- would have to pay higher interest rates to entice investors to borrow more.

In fact, that's what many bond investors expect.

"It seems as if market participants are anticipating higher long- and short-term rates by the end of the year," said Jim Cusser, senior vice president and portfolio manager for Waddell & Reed in Kansas City.

All indications are that the $3.2-trillion U.S. Treasury market is destined to get bigger. President Bush's proposed budget projects a record $304-billion deficit for the current fiscal year and $307-billion for the year that begins Oct. 1.

And that may not even be the extent of it because projections often turn out to be rosier than reality. The administration had been projecting budget surpluses for the rest of this decade. Eventually, they would have wiped out the national debt. Instead, after four years of shrinking, the debt is growing again.

But all things are never equal, and some experts say it's by no means certain the deficit will mean higher interest rates in the near future.

"It's a mistake to make an automatic link between rising bond yields and budget deficits," said Mike Smith, a director at Avebury Asset Management, a London money management company that specializes in fixed income investments.

Changes in government borrowing habits are one of several factors influencing bond prices and interest rates.

In a lackluster economy, corporations borrow less, either because they don't need the money to finance growth or because their credit is weak. When corporations aren't issuing so many bonds, the government can issue more without flooding the market. Investor expectations also play a role. When expectations are for a weak economy, demand for bonds stays high, which tends to keep interest rates low.

Currently investor demand is robust because of the weak economy and because of government bonds' perceived safety. When wars and political turmoil make investors nervous, they stash their money in U.S. Treasuries. It also helps that the stock market has been a rotten performer: Even low bond yields are better than losing money.

"We still have an awful lot of slack in the economy," Cusser, the portfolio manager, said. "Even if Saddam Hussein were to give up tomorrow, we have a lot in the world that's depressing consumer confidence. As long as inflation is under control and as long as there is concern on people's minds about investing, there will be greater than normal demand for bonds."

Bond investors have to keep an eye on all those things.

"Our central view here at Avebury is that bonds are pretty safe for the time being," Smith said. "We are predicting slightly higher yields toward year-end, assuming the Iraqi situation is resolved without too many problems. The U.S. economic recovery will start to build on itself. That will help push bond yields up very slightly, at least at the longer end."

He said he doubts that the Federal Reserve will make any efforts this year to nudge short-term interest rates back up.

One thing bond investors have to keep an eye on is the stock market. If it gets rolling again, it will offer more competition to bonds for investors' money.

"If stocks do perk up, then we'll start seeing money flow out of bond funds back into stocks," said Cusser at Waddell and Reed, so bond issuers would have to offer higher yields.

President Bush's proposal to eliminate income tax on most stock dividends also would give stocks an advantage over bonds.

Investors who are trying to read the bond market tea leaves should keep in mind that it is not a single market but many. Treasuries, municipal bonds, high-quality corporate bonds, low-quality junk bonds and foreign bonds are all important sectors. An increase in Treasury bond issuance would have more impact on that part of the market than it would on, say, foreign bonds.

Smith at Avebury said he favors corporate bonds and European bonds because he thinks those sectors will do better than Treasuries.

What should individual investors do?

Be careful, the experts say.

Interest rates and bond prices operate like the ends of a playground teeter totter. When rates go up, bond prices go down -- and vice versa. That doesn't matter if you own individual bonds you hold to maturity. But it matters a lot if you own a bond mutual fund or if you need to sell individual bonds before maturity.

"I am very concerned that many people who have sought the safety of bonds, particularly over the past year, are going to be very shocked at how quickly their investment can be eroded by rising interest rates," said Clearwater financial planner Ray Ferrara of ProVise Management Group. "Long rates could move very quickly. A 1 percent increase in those rates would translate into an 11 to 12 percent decline in the long-term bond price. Those who say 'I'll get out when interest rates start to go up' are the same ones who said 'I'll get out of the stock market when stocks start to go down.' "

The most conservative stance is to stay short, since prices of short-term bonds fluctuate the least in response to changes in interest rates. The down side is that most of the time they also pay the lowest interest rates.

Another alternative is to match spending needs to bond maturities. If you buy a Treasury security that will mature when you need the money, you don't worry about it in the interim.

Still another approach is to try to mine other sectors, such as corporate bonds, which generally improve along with the economy and pay higher yields in the meantime. Of course, many bond investors already have thought of this. Prices have rallied over the last few months. Since Oct. 1, corporate bonds rated BBB have returned more than 5 percent.

When buying any type of individual bonds, it is important to stick with high-quality bonds and to assemble a diversified portfolio. Default is always a risk with corporate issuers, particularly those with low credit ratings.

-- Helen Huntley can be reached at huntley@sptimes.com or (727) 893-8230.

Who owns U.S. Treasury securities?

Foreign investors: 34.3%

U.S. monetary authorities: 19.3%

Individuals: 10.4%

Pension funds: 9.6%

Mutual funds: 8.7%

Banks: 7.2%

State & local governments: 3.9%

Insurance companies: 3.6%

Other: 3.0%

Statistics are as of June 30, 2002, and do not include savings bonds

Source: Bond Market Association

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