Bond investors, who just suffered through the worst year in the bond market since 1927, should be welcoming the new year with open arms.

The carnage in 1994 was everywhere. The loss in market value in fixed-income securities through November was $1 trillion, according to a report from the Securities Industry Association. For the first time since its inception in 1976, the Lehman Brothers Aggregate Bond Index showed a negative total return for 1994. Mutual funds recorded a net outflow of money from fixed-income funds, and for securities underwriters, the overall volume of new issues underwritten in 1994 was anywhere from one-third to one-half less than in 1993.

Many firms have suffered sizable losses in their trading accounts, employees are being laid off at brokerage houses, and bonuses may be nonexistent.

What makes 1994 all the more intriguing is that it was a complete reversal from 1993. What a difference a year makes. In 1993, interest rates plunged and financing volume was heavy. Investment houses underwrote a record volume of new issues and earned record fees. Investors saw their financial assets zoom in value and all was right with the world.

But 1994 doused bond investors with a bathtub full of ice water. The stock market for the most part moved sideways, but the bond market was decimated from the time the Federal Reserve began raising short-term interest rates -- including the federal funds rate, what banks charge each other for overnight loans -- on Feb. 4. Responding to the torrid growth in gross domestic product of 5.9 percent during the fourth quarter of 1993, the Fed attempted to short-circuit the return of inflation that it had labored so hard and so long to bring under control.

Ward McCarthy of Stone & McCarthy Research Associates believes that the two primary influences on interest rates in 1994 were the widespread perception that the economy was growing too fast, which would lead to a rekindling of inflation, and the Fed's efforts to keep the economy from growing above the level it perceived to be inflation-free growth -- gross domestic product rising at a 2.5 percent annual rate. The Federal Reserve raised the federal funds rate six times -- 250 basis points in all, from 3 percent to 5.5 percent.

Lou Crandall of R.H. Wrightson & Associates Inc. cites another factor affecting rates: the relatively steep yield curve that persisted throughout most of the year.

At the beginning of 1994, the spread between the federal funds rate and the 30-year Treasury bond was 325 basis points (3 percent to 6.25 percent). By the end of the year, that spread had narrowed to 235 basis points (5.5 percent to 7.85 percent). This meant that it was very inviting for investors, speculators and hedge funds to borrow short at the relatively low federal funds rate, and to invest in longer issues at a much higher rate.

The only problem was that as short-term interest rates rose, the prices of longer-term bonds sold off more drastically than the prices of short-term investments. It also meant that the cost of borrowing short-term kept rising with each Fed initiative.

The result: a classic two-way squeeze that manifested itself with each Fed rate increase by some financial crisis, from the highly leveraged hedge funds in the spring to Orange County in the fall. This two-way squeeze in itself created additional volatility in the longer-term sectors of the bond market.

The direction of interest rates now depends on the strength of the economy, inflation and the Federal Reserve's response to those factors. Most observers believe that the Fed will raise the federal funds rate from 5.5 percent to perhaps as much as 7 percent by mid-1995 before the economy begins to slow. By year-end, they say long-term rates could fall to 7.25 percent, which means a flat yield curve.

As chastened bond investors look to this year, those who want to stay relatively short-term might look at buying bonds maturing up to five years from now, once the Fed starts to lift rates in 1995. Rising short rates should help the dollar, which in turn should be positive for bonds.

As to long-term investors, as the 30-year bond moves back to 8 percent, it might be a good time to buy longer-term fixed-income investments.

With inflation on the benign side, and with the Fed seemingly ahead of the inflation curve, we may experience longer business cycles with much lower interest rates. Should this come true, investors will look back to the first half of 1995 and wish that they had bought more bonds. For 1995, long-term bond indexes could show a 12 percent to 15 percent total return. The surprise in to this scenario would be a continuing strong economy throughout 1995.

Here's a rundown of bond performance last year by sector:

* Government bonds: Jim Kenney, head government trader at Prudential Corp., characterized the year as one of "survival." The Treasury market took a good portion of the beating over the year and was the only one that offered any liquidity. With the fallout that occurred from derivatives, mortgages, agencies, options and swaps, the Treasury market was used as a hedge. As a result, Treasuries were under a great deal of pressure from February on, and the large number of speculators operating in the market led to a reduction in the number of government traders who were willing to take risks in such a volatile market.

* Municipal bonds: There was an erosion in investor confidence as shown by the net redemptions in shares of tax-exempt mutual funds. Contributing to this loss of confidence was concern over derivatives, poor performance numbers and declines in the net asset values of funds. The shock of Orange County didn't help either. When individuals bought munis, they bought mainly from brokers, rather than investing in mutual funds.

Rising interest rates shut down the refunding of outstanding issues with new issues bearing lower interest rates. It is estimated that 1994's tax-exempt refund- ings -- about $50 billion -- will be 74 percent less than the $193 billion of refundings in 1993. On the positive side, new money or new capital issuance surged by 16.5 percent this year over 1993, with education and housing being the chief recipients of the proceeds.

* Corporate bonds: The large downturn in new-issue supply was the significant factor in the corporate market, said Seth Waugh, managing director of Merrill Lynch & Co.'s institutional trading. This is for three reasons: high interest rates; the large amount of pre-refunding of corporate issues from 1991 to 1993, when interest rates were low; and good corporate earnings, which reduced the need for capital. Attesting to the lack of need for funds domestically was the fact that the volume of new issues underwritten in the Eurobond market was almost double the volume underwritten in the United States.

In the high-yield sector, demand fell dramatically as investors redeemed shares in their high-yield bond funds. This lack of demand was borne out by a 46 percent decline in new high-yield issues that were underwritten in 1994. As such, they represented only 16 percent of the total corporate new-issue calendar, down from 19 percent in 1993. Noteworthy too was the increased borrowing in U.S. markets by foreign companies, especially Asian entities.

* International bonds: "A disaster" was how Robert Lawrie, a vice president and international analyst at Merrill Lynch, described this market in 1994. The reasons cited by Lawrie were "that we're in a global bond market now, no longer individual countries and economies." With the dramatic sell-off in the United States, markets in all the industrial countries were affected.

Coupled with this globalization was the fact that European countries came out of their recession much faster and stronger than anticipated, followed by Japan. With a global market, Lawrie feels that it may be difficult for U.S. rates to decline too far when our economy peaks and the economies and interest rates of the other industrialized nations are still on the rise.

The recent peso crisis also has hurt investor confidence, not only in Mexican bonds, but in the investments of other emerging-market countries. It may take some time for this problem to sort itself out, and volatility should be the order of the day in those already volatile markets.

CAPTION: THE BOND SQUEEZE (Chart is not available.)