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.