September 17, 1998 Shocks and Aftershocks: The Bear Is Rampant in the Markets for Riskier Bonds By GRETCHEN MORGENSON NEW YORK -- The stock market's bear may have gone into hibernation, but the bond market variety is all too alive and well. Having endured an August from hell in stocks, investors are enjoying a respite in September. But while many stocks have bounced part way back from their losses, bonds -- with the conspicuous exception of U.S. Treasury securities -- have barely budged. August, one of the most brutal months on record in almost every bond market around the world, has been followed by a September in which most of these securities, even if they are up, have mustered only the merest of gains. What happened? Through no fault of their own, investors in a wide variety of bonds, from convertibles to mortgage-backed securities, found themselves trapped in a game of economic dominos gone awry. The bond market action in August is a painful lesson in how the toppling of one market can, in turn, hurt even the most seemingly unrelated market worlds away. What began in mid-August with a apparently irrelevant de facto default on its debt by the Russian central bank wound up hurting even the most highly rated bonds issued by U.S. corporations with absolutely no exposure to Russia. The only people who escaped the disaster were owners of U.S. Treasury securities, which were driven to historic highs in price terms as a result of some of the lowest yields in decades. The situation in Russia caused an about-face in the level of risk that professional investors were willing to tolerate. As long as the International Monetary Fund was willing to bail out countries experiencing economic disarray, investors were comfortable investing in fledgling markets. Russia changed all that. "The flight to quality, previously, was out of equities and into bonds, and any bonds qualified," said Martin Fridson, chief high yield strategist at Merrill Lynch. "Now that flight is much more pronounced because investors want to go all the way to the ultimate quality of U.S. Treasury securities. Nothing in between seems safe enough." What did this new risk aversion mean for various bond markets? Big losses. In August, investors in emerging market debt lost 28.7 percent of their money, convertible bonds lost 11.8 percent and high-yield bonds lost 7.4 percent of their value. Real estate investment trusts that invest in mortgage securities declined an average 27 percent during the month. Only two non-Treasury sectors showed gains for the period: municipal bonds rose 1.92 percent and the highest-rated corporate bonds inched up 0.51 percent. Treasury bonds, meanwhile, advanced 2.16 percent. Bonds, remember, are supposed to be boring, predictable investments. No more. "We've probably crammed about a year of volatility into the last six weeks in the bond market," said Randall King, senior vice president of asset liability management at PNC Bank in Pittsburgh. The result of all this volatility has been to bring the issuance of many types of bonds and convertible debt to a near standstill. For example, only one convertible debt issue came to market in all of August. Why does upheaval in one distant market make for losses closer to home? T. Anne Cox, director of global convertible bond research at Merrill Lynch explained: "If investors take a hit in one part of their book, their risk tolerance is going to decline across the board. And if everybody does that at roughly the same time, you could see where you'd get some real liquidity pressure." Hurt the most by the bear market in bonds are hedge funds that made big bets in emerging market debt and brokerage firms that trade all manner of bonds for their own accounts. Also taking a hit were commercial banks that trade in the same markets. Adding to the upset, many of these concerns used leverage to make their bets, which magnified their losses. Another piece of bad luck: these big investors typically hedged against losses in emerging market debt by selling Treasury securities that they did not own. With prices of Treasuries roaring as emerging market debt plunged, the "hedges" were a disaster as folks found themselves on the wrong side of both of their trades. As a result, word on Wall Street is that most fixed-income departments at major trading firms have given up all they had made during the first seven months of the year. These departments usually are big money makers for brokerage firms. Last year, for example, Merrill Lynch's taxable fixed-income department generated nearly $1 billion in revenue, 26 percent of the firm's overall revenue for principal transactions. This year, however, bonuses for employees in these areas are a dream; many firms have already conducted what are euphemistically called head-count meetings. Firings will follow. For individuals, the unhappy sequence of events in the bond market is all that much harder to take because the losses came when interest rates were declining significantly. Yields on the five-year Treasury note, for example, have fallen one full percentage point in recent weeks. The notes traded at 5.43 percent on July 1 and fell to 4.43 percent on Sept. 11. Wednesday they were a little higher at 4.67 percent. With rates moving down, investors are understandably confounded by losses in their bond portfolios. After all, doesn't Investing 101 dictate that when interest rates fall, bond prices rise? Indeed it does. But Investing 101 could not have predicted the confluence of events -- the work of professional investors, hedge funds managers and brokerage trading desks which ran away from anything with a whiff of risk to it -- that have paralyzed worldwide bond markets. As the herd stampeded out of junk bonds, convertible debt, emerging market bonds, even relatively unrisky corporate issues, buyers for these securities disappeared. Typically, bonds of all kinds trade in tandem. But not in this market; Treasuries have broken away from the pack. "Everybody's focused on the decoupling of stocks and bonds," said Michael Ryan, senior fixed-income strategist at Paine Webber. "What they're not focused on is the decoupling of fixed income." All fixed-income securities, whether convertibles, high-yield bonds, AAA-rated corporates or mortgage-backed issues, are traditionally evaluated by how much more their coupons yield than Treasury securities with similar maturities. Because Treasuries are as close to a risk-free investment as there is, any bond that is not backed by Uncle Sam has to attract investors with a higher interest rate than those investors would get if they bought Treasuries. Historically, the average premium at which high-yield bonds, commonly referred to as junk bonds, have traded, for example, is a little under 4 percentage points higher than similar Treasuries. Now their yields are almost 6 percentage points higher than Treasuries. But at the end of last year, according to John DeMeo at Salomon Smith Barney, junk bonds traded at a much smaller premium to Treasuries: a little more than 2 3/4 percentage points above the government's issues. This narrow spread was the result of yield-starved investors taking as big a gamble as they dared. Those were the days when investors were utterly confident that there was relatively little risk in reaching for that larger return. So, in the months before what was to be a historic flight to quality, the extra spreads for all non-Treasury debt were extremely narrow. When investors fled, they were fleeing from bonds that were, by traditional standards, highly priced. That only compounded the losses. Each market has, to some degree, slightly different reasons for its troubles. Convertible bonds, for example, are tied to the fortunes of the typically small stocks that are embedded in their values. These shares have been pummeled by the bear market in small-company equities. Junk bonds, because they are issued by companies most vulnerable to problems stemming from declines in corporate profits, may also reflect the recent difficulties in small-company stocks and worries about a recession in the United States. Most investors have probably been unaware of the recent carnage taking place in bonds. That's because it is a much more disparate and less transparent market than the stock market. While it's relatively easy to watch the stock market's ups and downs -- every move is detailed daily in newspapers, on Internet sites and on cable television shows -- bond markets are much harder to track. Because information about trades in these markets is not widely available, only professional traders and institutional investors involved in the worldwide bond markets had a ringside seat for the ugly events unfolding there over the past six weeks. Toting up the dollars lost by investors in bonds in August is difficult, too, because of the market's opaqueness. But some numbers are available: $48 billion was lost in emerging market debt that was denominated in dollars, $14.6 billion disappeared from portfolios of convertible bonds, another $15 billion was likely lost in junk bonds and $1.67 billion disappeared during the month from an index of real estate investment trusts that invest in mortgage securities. That's about $80 billion lost. Investors who are not yet aware of the recent turmoil in bonds may get an unpleasant jolt when they check their mutual fund holdings. There are plenty of bondholders out there: as of Sept. 9, according to AMG Data Services, assets held in bond funds totaled $533 billion, roughly one-fifth the amount currently in stock funds. A paralysis unlike anything investors have seen for years is gripping non-Treasury bond markets in the United States. Investors who think that September's relative calm in the market is a sign of stability should not be confused. It is a frozen market, where nobody's selling because there are no buyers. "It's an over-the-counter market and you've got to get these guys to pick up the phone," said Carol Levenson, editor of Gimme Credit, a corporate bond advisory service to institutional investors in Chicago, Dealers at major Wall Street brokerage firms are no longer bidding for bonds from their customers; they will only take an order if they know they have another customer interested in owning the bonds. And since few investors are interested in adding to their bond positions until they see the market stabilize, most sell orders don't get executed. As a result, the losses that have been registered in bonds so far probably reflect only a fraction of the real damage done to these markets. If there was actual selling going on, the prices would be far lower. But as long as investors are not forced to sell, the market simply feels ominously quiet. With the year winding down, more and more investors may be forced to sell their holdings. If the market does not rebound by the end of the year, many large firms want to have their trading portfolios whittled down. What might the next few months bring to bond investors? Don't expect a big rebound. With Federal Reserve Chairman Alan Greenspan declining to elaborate on investors' hopes that he will cut interest rates at the Sept. 29 meeting, the market in all but Treasuries will likely remain frozen.