The bond market -- where risk-averse investors used to lend money to companies and governments for long-term, guaranteed returns -- is dying.
It is being strangled by high interest rates, fears of future inflation-producing budget deficits and a general lack of investor confidence in the Reagan administration and the economy.
Unless companies and governments are able to sell long-term debt, the expansions, modernizations and capital improvements needed in industry and public projects will be curtailed. The longer the bond market is moribund, the more ominous the consequences.
"It's not the end of the world," said Andrew Morse, vice president of the big brokerage firm Drexel Burnham Lambert Inc. But the situation is deteriorating, he said.
Observers such as Morse and Merrill Lynch & Co.'s Peter Goldsmith think the high interest rates, curtailments in capital spending and federal budget cuts eventually will trigger a severe business decline. Stock market investors apparently think so, too. Stock prices have tumbled sharply in recent weeks.
Unable to sell bonds, many companies and municipal governments are scaling back expansion or modernization plans. Washington Public Power System, the nation's biggest issuer of tax-exempt bonds, said last week it is running out of money and may have to halt work on two nuclear power plants. The company hopes to sell $450 million in bonds this week and will need to raise more money next month.
Baltimore Gas & Electric Co., facing the prospect of paying 17 1/4 percent for 10 years on its planned $100 million bond issue, last week canceled the sale. Cook County, Ill., one of the highest-rated municipal governments, balked at paying 13.06 percent for a $60 million bond issue on which interest payments are tax-exempt for investors. Chicago, whose bond rating is lower than Cook County (in which it sits) may be unable to raise the $140 million it needs to bail out its troubled transit system.
"There is a general abandonment of the bond market by almost all participants," said Frank Trainer, vice president of Sanford Bernstein & Co., a Wall Street brokerage firm that deals mainly with big institutional investors such as pension funds and insurance companies. Prices of bonds, which move inversely to interest rates, are at record lows.
Even more distressing to traditional bond buyers than low prices, however, is the volatility of those prices. Bond prices can rise or fall as much as $20 or $30 a day for a bond with a face value of $1,000. A decade ago, bond prices did not change that much in two years. "The people that are still buying bonds are speculative investors who treat them like stocks," Trainer said.
Investors and financiers -- battered by high interest rates and inflation for years -- increasingly are disaffected with the Reagan administration's economic policies. The highly touted tax cut, Wall Street fears, will increase sharply the federal government's deficit next year, despite the $35 billion of budget trims Reagan pushed through Congress for fiscal 1982, which begins Oct. 1. The Congressional Budget Office estimates the deficit will be $60 billion rather than the $42 billion the administration estimates.
The government has to finance that deficit by borrowing, and investors fear that such a large deficit makes it more difficult than ever for local governments and private companies to borrow, pushing up the cost of long-term debt even more.
The administration is trying to find new areas to cut in the budget -- and may have to trim the defense area, once thought to be sacrosanct in the Reagan administration.
But White House spokesman Larry Speakes said last week that there will be no "full-scale blitz" to convince Wall Street that the Reagan policies will bring about a stable, noninflationary economy. Speakes said Wall Street will discover that the Reagan policies will work.
In the meantime, however, companies and local governments are starving for the kind of long-term borrowing that results in stable expansion and reasonable interest costs. Interest rates are twice the inflation rate.
Already many companies are scaling back their investments, unwilling to pay interest rates of 16 percent or 17 percent for 30 years. That's bad news for an economy that most economists believe requires massive investments for modernization and expansion.
Unable to borrow in the long-term market, companies are finding themselves saddled with more short-term borrowing than they want or consider desirable. While investors are afraid to tie up their money for 10, 20 or 30 years, companies have little trouble finding short-term loans, albeit at high cost.
Many of those companies would like to issue bonds and use the proceeds to repay short-term borrowings. They cannot. As a result, their balance sheets are subject to the vicissitudes of the short-term money market.
Interest costs as a percentage of profits are rising, in some cases to unhealthy levels. Henry Kaufman, chief economist of the investment banking firm Salomon Bros., estimates that nonfinancial companies paid net interest at a $62.4 billion annual rate through the first six months of this year. Net interest costs to those companies totaled $56.1 billion last year and averaged about $40 billion a year between 1976 and 1980.
Municipal governments are finding their borrowing plans shattered under the pain of high interest rates. When Reagan administration budget cuts begin to bite this fall, state and local governments will be hard-pressed to replace the lost federal funds by borrowing until taxes can be raised or services reassessed.
Municipal bonds are hit even harder than corporate bonds. Interest income on most municipal offerings are exempt from federal taxes, and issuers of those bonds generally have had to pay rates about 70 percent of what the U.S. government had to pay to sell its debt securities. In some cases, municipalities find themselves paying as much or more than the federal government.
Two of the main purchasers of municipal bonds -- banks and casualty insurance companies -- have stopped buying them. Banks, because of their changing business, have found less need in recent years for tax-exempt income, while casualty insurance companies, facing profit problems this year, also are buying fewer tax-exempt securities, according to Robert Mott, sales manager of the municipal bond division at Chicago's Continental Illinois National Bank.
Although sky-high interest rates are a large part of the bond market's malaise, even a sharp decline in rates may not revive the long-term debt markets, analysts say.
Rates are high, in large part because the Federal Reserve, the nation's central bank, is embarked on a tight-money policy designed to wring inflation out of the economy by making money and credit more difficult to obtain. To no small degree, the Fed seems to have succeeded in reducing the rate of growth of the money supply this year. Inflation this year has subsided as well.
There is some evidence, none of it more than circumstantial since the Fed never announces its policies in advance, that the central bank is starting to relax its tight grip on the money supply.
But several times in the past two years interest rates fell and the battered bond market recovered strength, only to be subjected to a new, more debilitating round of interest-rate increases.
"The scars run deep," said Sanford Bernstein's Trainer. It will take a sustained period of lower rates to bring investors back.
But with bonds carrying interest yields as high as 17 percent, a number of analysts think they are a good investment now. Merrill Lynch's Goldsmith said the recession he thinks is inevitable will bring down interest rates because business and consumer demand for credit will shrink.
Goldsmith and his colleagues at Merrill Lynch thought the same thing in June. Since then bond prices have fallen as much as $100.
"We're not trying to call the turn," he said, but addded that rates will fall. "Maybe today. Maybe not for three months, maybe longer." When they do, the investor with a guaranteed 17 percent return is in good shape.
Unless the projected recession puts the bond issuer out of business.