Corporate and municipal borrowers are being backed up against a wall as plummeting bond prices force them to pay record interest rates in order to sell their long-term securities.
"Corporations and municipalities don't know what to do," said Peter Goldsmith, director of fixed-income research at Merrill Lynch, Pierce, Fenner & Smith.
"We don't know what to tell them," said John Gutfreund, managing partner of the major investment banking firm Salomon Brothers.
Should a corporation decide to borrow from a bank or some other short-term lender to avoid paying 15 percent interest for 30 years in anticipation that interest rates will come down? Or should the company sell bonds today to avoid having to pay 20 percent interest a month or two months from now?
That is the type of question corporations, municipal and state governments, and their advisers -- the banks and the investment bankers -- are asking themselves, but they are not coming up with adequate answers.
In recent days, a number of state and local governments either have postponed or cancelled planned bonds sales, and several governments that went ahead with the sales subsequently rejected all bids because the interest rates were too high.
Banks are bracing for a big upsurge in loan demand from companies and municipalities who have decided to finance their long-term needs with short-term loans until long-term interest rates subside.
"Our numbers aren't reflecting it yet, it's premature. But our intelligence tells us to anticipate a big increase in loan demand," said George Baker, executive vice president of Continental Illinois National Bank, the nation's seventh largest.
Robert H. B. Baldwin, chairman of Morgan, Stanley & Co., perhaps the nation's leading investment banking firm, said that the bond market collapse -- seven weeks old and getting worse -- soon could lead to postponements or cancellations of major industrial projects as the cost of raising money to finance them exceeds the rate of return a company expects to earn.
That, in turn, will hurt productivity and worsen the inflation that Baldwin and most other analysts see as the root cause of the bond market debacle.
Analysts are at a loss to explain the speed and devastation that has beset the market for long-term debt securities, mainly bonds.
Although nearly all point the finger at rampant inflation, a high rate of inflation has plagued the country for several years. But except for a plunge last October, from which they recovered in November and December, bond prices had been declining only slightly, although steadily, for the last few years.
But beginning in January, bond prices began to nosedive, and that decline has been accelerating in recent weeks.
According to figures complied by Merrill Lynch's Goldsmith, Treasury bonds worth $1,000 on Jan. 1 were worth about $770 on Friday. And because Treasury issues are virtually risk-free, they suffer less than corporate or municipal securities.
"Creeping inflation is beginning to gallop into the bond market," said Henry Kaufman, chief economist for Salomon and one of Wall Street's most respected economists. His gloomy speech last Thursday knocked the pins out of a bond market that seemed to be rallying in the morning. Add to that some technical factors, Kaufman said: Some major buyers of bonds, such as insurance companies and pension funds, have their funds committed elsewhere, at least temporarily, reducing demand for bonds and therefore lowering their price.
But whatever the reasons, the bond market decline is getting worse. According to Goldsmith, bond prices fell almost as much last week as they did during all of January, after the government announced that wholesale prices rose at an annual rate in excess of 20 percent last month, far faster than anyone anticipated.
The decline in bond prices is upsetting normal financing patterns of companies and governments.
"Companies who were considering paying off their short-term debts with long-term funds are saying 'uh-uh'," said Frederick Joseph, executive vice president of Drexel Burnham Lambert Inc.
If the companies snub the bond market -- some, such as utilities, cannot -- then pressures will be increased on banks or the commercial paper market (essentially a market in which companies with spare cash lend to companies in need of cash for a short period of time).
If Federal Reserve Chairman Paul A. Volcker is as resolute as he claims to be about cutting down on money growth and bank credit expansion, then a classic credit crunch -- in which some borrowers find it impossible to borrow at any price -- could ensue.
Irwin Kellner of Manufacturers Hanover Trust, who has less faith in the Federal Reserve's resolve than some, noted that in testimony last week before the House Banking Committee Volcker "omitted any reference to avoiding a credit crunch."
Credit crunch or not, many borrowers are backing out of the long-term market, at least temporarily.
On Tuesday the State of Oregon said the 9.17 percent "best bid" it got on $31 million of its housing bonds was too high and rejected it. The State of Massachusetts said the same thing Wednesday about the 9.12 percent bid it got on $64 million of bond anticipation notes (because many state and local securities pay interest that is free from federal taxation, rates are lower than on Treasury or corporate issues).
New York City, which had planned to sell short-term notes to the public, announced instead that it would sell them under a prior arrangement to a group of 40 banks. The 9.5 percent that New York would have to pay the banks would be less than the cost of selling the notes to the public, city officials said.
Other state and municipal governments have decided to hold off on planned sales of their securities -- including New Jersey, Downers Grove, Ill., and the North Carolina Housing Finance Agency.
Some municipalities are subject to "arbitrary interest limits and many won't even bother to announce a sale because they know they won't get bids within the limitations," said David Taylor of Continental Illinois. Unless they face similar limitations on their short-term borrowing, these municipalities will be forced to go to banks.
Other municipalities may be forced to pay the higher rates whether they want to or not, noted Salomon's Gutfreund. Often they do not have the flexibility to reject bids, like Oregon or Massachusetts -- or to postpone their offerings. "The higher rates will become just one more burden taxpayers must bear," Gutfreund said.
Despite the high rates, the bond calendar is crowded, in part because utilities and others that postponed selling securities during the October decline cannot wait any longer. Few are industrial corporations. t
Utilities, mandated by law to have adequate generating capacity and faced with sharply rising construction costs, are selling their bonds because they have to, even if they must pay 15 percent.
That is a burden that will be borne by electrical users.