(FORTUNE Magazine) – THE REVERBERATING boom in the bond market was one of the big investment surprises of 1995. Often considered mere defensive afterthoughts by investors, bonds produced returns almost as fat as those delivered by the big bull stock market. Since year-end 1994, 30-year Treasuries have provided a towering total return of over 25%. Most of that came from a surge in bond prices as yields dropped from 7.85% to 6.25%; the rest came from interest payments. So what's the prudent thing to do now, if you were lucky or smart enough to be in bonds last year? Should you take the money and run--on the theory that bust must inevitably follow boom--or sit tight? And if you missed the big move up, should you just shrug and forget about bonds?

Well, you might just want to consider buying bonds right now. It would be miraculous, of course, if 1996 returns came anywhere close to those in 1995, but there are excellent reasons to believe the bond rally could continue. Bond buyers might even reap returns in the low double digits, much more than in money market funds or CDs, and--who knows?--perhaps even more than in stocks.

The main argument for bond market bullishness is that slow-to-modest economic growth and a receding inflation rate will lead to even lower interest rates, boosting the value of existing bonds. That's what happened big time in 1995, but as the chart at the right shows, bond yields still have room to decline because of the wide gap between yields and labor-cost inflation, an important precursor of overall inflation.

Second comes the conviction that Washington will eventually deliver on its efforts to cut the federal budget--and thus give another boost to the bond market. Jerry Paul, in charge of fixed-income investing at Invesco, a mutual fund company, thinks the yield on long-term Treasuries could drop to 5.75% by the end of 1996. If he's right, investors buying bonds today would wind up with a total return of about 12%. Even if long-term interest rates don't change at all, bondholders would earn some 3.5 points above inflation--"a good real return," notes Paul.

Don't misunderstand. A bull market for bonds in 1996 is hardly a sure thing. Some respected analysts think the market could deteriorate. BOND OUTLOOK DARKENING, reads the headline on a marketing letter from the Bank Credit Analyst research group, a consulting firm that advises financial institutions and corporations. BCA argues that the economic slowdown in 1995's first half--slow growth, remember, is good for bonds--was just the temporary result of a monetary squeeze in late 1994 and the Mexican financial crisis in early 1995. Swiss Bank's head of economic research, Ken Bercuson, predicts the long-bond yield will approach 8% sometime in 1996--which would produce severe losses for bondholders. Bercuson argues that wage inflation will pick up because the labor market is tight, prompting the Federal Reserve to raise interest rates.

But most bond market pros are resolutely optimistic about the medium-term outlook. Here are six solid reasons why investing in bonds can continue to pay off in 1996:

Inflation. It seems down for the count. Companies continue to be obsessed with cost cutting. For more than a year now, the unemployment rate has stayed below 6%, supposedly the flash point for wage acceleration, yet employee compensation continues to decelerate. The leading index of inflation computed at Columbia University has been falling for the past half year. Says Barbara Kenworthy, who manages more than $2 billion in bonds for Prudential: "Inflation is surprisingly low and is still lending positive momentum to the bond market." NationsBank chief financial economist Mickey Levy thinks lower inflation will prompt the Fed to cut its key interest rate, the federal funds rate, to 4.5% by year-end 1996--a point and a quarter below its level in early December. He expects the yield on the 30-year bond will fall to 5.75% at midyear. Another influential Wall Street economist, Ed Hyman of ISI, an investment advisory firm, expects declining inflation will lead to a 5.6% bond yield in the third quarter of 1996.

The economy. Signs of economic sluggishness abound, raising the odds of a Fed rate cut. Retail sales are weak, unemployment claims are rising, and real wages are flat. John Liscio, who publishes a market newsletter in Montclair, New Jersey, tracks state tax-revenue figures to get a reading of the economy's direction. They have fallen sharply from a year ago, he says, "showing a dramatic economic slowdown." Other analysts note that big export markets are weak--Mexico, Europe, Japan.

Washington. The federal budget contains good news for bond investors. The budget-cutting package that took shape in late 1995 "represents the most dramatic deficit reduction in history," says Kevin Kleinsmith, head of fixed-income trading at McDonald & Co. Along with many others, he believes the Fed will cut rates in response to a budget deal. In the short term, most economists think budget cutting slows the economy, furthering the case for low inflation. In the long run, less federal borrowing means the Treasury will issue fewer bonds, thus reducing supply and boosting prices.

Investor demand. Faced with declining short-term rates, investors in search of higher yields will buy bonds. According to ISI, individuals enjoying rates exceeding 5% on CDs and money market funds have stuffed more than $200 billion into those investments in the past year, for a total of $1.4 trillion. Jerry Paul of Invesco thinks those rates could fall below 4% in 1996. When short rates fell earlier in this decade, money flooded into bonds, helping produce the excellent returns shown in the chart on this page. Also, money could flow to bonds from stocks as corporate earnings growth--and the stock market--cools off.

Bank demand. Domestic and Japanese banks could be bigger bond buyers in 1996. Merrill Lynch argues that as slower U.S. economic growth reduces loan demand, domestic banks will find themselves with spare funds to invest in Treasury securities. Japanese banks, trying to repair decimated balance sheets, should find Treasuries especially attractive at current exchange rates, since yields on Japanese government bonds are paltry--under 3%. In the first half of 1995, foreign investors helped reduce U.S. interest rates by purchasing a record $76 billion, net, of U.S. Treasury notes and bonds, according to the Securities Industry Association.

The Fed. The last bond boom--in 1993--was sparked after the Fed slashed short-term interest rates to help the economy struggle out of the 1990-91 recession. But when the Fed's rate cutting led to stronger economic growth and then higher rates in 1994, the bond market sold off in a big way, and investors got slaughtered. This time, in contrast, the Fed made just one small rate cut as bonds roared in 1995, so there's virtually no chance the Fed will tighten in 1996 as it did in 1994. What's more, the 1993-94 cycle was exaggerated by hedge fund managers and other highfliers--remember Orange County?--who borrowed cheap short-term money in 1993 to buy higher-yielding securities, including exotic derivatives. "People stepped out beyond their learning curve," says Kleinsmith of McDonald & Co. Came the rate hikes of 1994, and these leveraged securities plunged in value and were difficult to unload. To raise funds to pay their loans, investors had to sell liquid holdings like Treasuries, causing sharp price declines. After that experience, "professionals today are focused on safety and liquidity," says Kleinsmith.

Here's a final reason to buy bonds: Eventually the economy will sink into recession--probably not in 1996, and maybe not in 1997 either. But if history is any guide, it will happen within the next few years, and when it does, stock prices will fall and bond prices will rise--as sure as taxes. In the meantime, inflation is down, the economy is far from overheated, the deficit is shrinking, and the Fed has proved it knows its job. Bond investors couldn't hope for much more.

Reporter Associate Tricia Welsh