The Big Bond Market Goes Bust

"I decided to go East and learn the bond business. Everybody I knew was in bonds."

--Nick Carraway in The Great Gatsby

Safe, sane and stable, the $2 trillion bond market used to provide a sinecure for men of high breeding and low wattage while supporting orphans, saving widows from penury and generating far more money than the stock market did for corporations and governments. Now this primary source of long-term lending has been pulverized by the twin forces of inflation and soaring interest rates, and staid bond dealers talk like teen-agers trading bubble-gum cards or posters of Pop heroes. They speak of swapping "Bo Dereks" and "James Bonds," slang for big bond issues that mature in 2010 and 2007.

Prices have plunged so sharply in recent months that even the most credit-worthy of borrowers are finding it tough and extremely costly to raise money. The result: less spending on plants, schools, roads, hospitals and other private and public projects. This will have a broad impact on U.S. society, because it retards industrial expansion, research and innovation. At the same time, the bond decline shakes public confidence in the nation's financial fabric. People wonder, if bonds are not safe, secure investments, what are?

Bonds have been falling ever since the Federal Reserve squeezed up interest rates last October. That is because whenever the cost of money climbs, bonds that had earlier sold at lower rates suddenly become less valuable than newer offerings that pay higher returns. But even those new bond offerings do not sell well. People are afraid to lock themselves into long-term fixed-income bonds; they figure that inflation will send interest rates still higher, and so they prefer to put their money into quick-in, quick-out investments that offer shorter terms or flexible yields. Bond yields may seem steep today, but if inflation keeps on roaring, they will not be as high as the returns on other investments tomorrow. Besides, if general interest rates keep rising, bond prices stand to decline further, and buyers will take a beating when they sell.

Fearful that inflation will continue and prices will keep falling, many once traditional bond buyers are investing elsewhere. Pension funds and insurance companies are putting more of their millions in the stock market; retirees, widows and other coupon clippers are switching into the safer and high-yielding money market funds, which pay about 13%.

At least four smaller bond-trading houses have gone bankrupt since October, but the biggest losers are the bond buyers, which range from huge pension funds to modest-income individuals. The investment banking house of Morgan Stanley estimates that bond values have plunged by more than $500 billion in the past six months, a drop of about 20%; an equivalent slide in the stock market would have sent the Dow Jones industrials down by about 160 points. Last fall investors paid $1 billion to buy new IBM bonds; they are now worth about $750 million.

Because the bond business is drying up and interest costs are so steep, many borrowers are being forced to postpone or cancel planned offerings. Particularly hard hit are cities and states that have counted on selling long-term bonds at low interest to pay for highways, hospitals and other projects. Because municipal bonds are exempt from federal tax and often state income tax, there used to be no shortage of buyers. But when St. Paul last month tried to raise $10.5 million to repair winter-ravaged streets, improve fire stations nd extend a sewage line, there were no takers; state law restricted the interest to 7%. New York State split up a $181 million fund raising that had been planned for December, figuring that it would pick up the bulk of the money later at cheaper rates. The ploy failed.

In December the state raised $81 million at a tax-free interest of 6.7%, and last month the remainder went for 8.78%, the highest rate New York has ever paid. That 2-point increase will cost the state millions of dollars in extra interest costs.

Last week New York City's Municipal Assistance Corporation canceled a $125 million offering because the anticipated rate--up to 10.5% tax-free--was simply too much. New Jersey delayed a $100 million offering that was supposed to finance mass-transit projects, sewers and a school for the retarded. Other big issues have been called off or postponed by South Carolina and Oregon, plus numerous communities. Says Lloyd Hara, the treasurer of Seattle: "We all just have to wait and hold back. The market has gone bananas."

The Federal Government is now paying over 15% for its three-month treasury bills, vs. about 10% last October. Corporations that a decade ago paid 7% or less to float triple-A issues now must pay at least 14%. Many top firms, including Texas Instruments, Citicorp and Household Finance, have pared or put off planned bond issues, thus reducing job-creating, growth-inducing investments. Since Jan. 1, at least $715 million in planned sales of corporate bonds have been delayed, and an additional $750 million are in limbo, with no fixed date for coming to the market.

The future of longterm, fixed-rate financing is in doubt, and inflation could well destroy the bond market. That has already happened in parts of Europe. West Germany's longterm, fixed-interest market was ruined during the Weimar Republic's hyperinflation; more recently, galloping prices have put Britain's bond market almost out of business. Companies in those countries have turned to such alternative sources of finance as stock offerings, bank loans and variable-rate loans. Short-term borrowing can be costlier and riskier than bonds, since companies cannot accurately predict costs. If inflation continues to ride high, U.S. bonds ultimately may become as valuable as those issued by the Confederacy.

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