The end of the treasury bull run

By Paul J. Lim, senior editor

(Money Magazine) -- Making money in bonds used to be so simple: All you had to do was put your dough into U.S. Treasuries and watch it rise.

Had you held your entire portfolio in U.S. government issues -- which have a minuscule chance of default because they're backed by the full faith and credit of Uncle Sam -- you'd have earned an annualized return of 8.5% over the past two decades. That's about half a percentage point a year ahead of the stock market and three points above their historical average.

Alas, "as far as Treasuries go, the good times are over," says Mario DeRose, fixed-income strategist for the brokerage Edward Jones.

That's because several unprecedented economic developments that fueled the bond boom are on the verge of reversing course. They include the precipitous decline in inflation (from double digits in the early 80s to virtually nil today) and the sharp drop in market interest rates (which sent yields of 10-year Treasury securities from more than 15% in 1981 to below 2.2% in early 2009).

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Those lower yields caused the prices of older, long-term bonds that pay higher rates to shoot up in the open market. Meanwhile, when the stock market went bust, investors around the world began fleeing to Treasury bonds as a safe haven. So much so, in fact, that Warren Buffett warned a year ago that a bubble was forming.

He called it, all right. As rates began to rise in 2009 -- thanks in part to an improving economy and growing inflation fears -- long-term government bond funds took it on the chin. They fell nearly 12% between the start of the year and mid-November.

Is this the start of a bear market in Treasuries? "It's certainly possible," says Peng Chen, president of the investment consulting firm Ibbotson Associates, "especially if inflation rises and the Federal Reserve has to raise interest rates aggressively to combat it."

All this may have you scrambling to figure out what, if anything, to do with Treasuries you currently hold -- and with your entire fixed-income portfolio, given that the same trends hitting Treasuries affect other bonds too.

Here are three smart strategies for the fixed-income holdings of three kinds of investors: those who can't stand the idea of losing a cent; those who are willing to take on more risk for a higher potential return; and those who fall somewhere in between.

Option 1: If you can't tolerate losing any principal

Stick with the feds, but do it the right way

A 100% U.S. Treasury strategy does away with credit risk: the possibility that the issuer won't be able to pay you back. But you still face the possibility that rates will rise, reducing your bonds' value in the open market. If you want to stick with U.S. government issues, make some changes to minimize that risk.

First, pare back on long-term exposure. Bonds that mature in seven or more years are more vulnerable to price swings than those maturing in less than three years.

Keep a portion of your Treasury holdings in individual issues, not funds. As long as you hold your bonds to maturity -- at which point the government will redeem your principal -- it won't matter if their value fluctuates in the meantime.

Ladder the bonds, splitting your money evenly among one-year, two-year, three-year, five-year, and seven-year securities. When your one-year T-bill matures, use that money to buy a new seven-year note. And so on. That way you'll never invest all your money when rates are lowest.

Put another slice into Treasury inflation-protected securities (TIPS). Yes, their market price could fall if rates rise. But these bonds offer peace of mind that regular Treasuries do not: Their principal value will at least keep pace with inflation. At today's yields you'll do better in TIPS than in Treasuries with the same maturity as long as inflation exceeds around 2% annually over the next decade -- a reasonably safe bet.

Finally, to add a little yield, put 10% into U.S. agency debt such as Ginnie Maes -- mortgage bonds tied to the Government National Mortgage Association, a federal agency. They're fully backed by the feds, yet give you a yield boost of about one percentage point over Treasuries.

An easy way to invest is via the Vanguard GNMA (VFIJX) fund (recent yield: 4.2%), which invests not only in Ginnie Maes but also in bonds issued by Fannie Mae. While that's not technically a government agency, it has been effectively nationalized.

Option 2: If you're willing to venture further afield

Stir in some debt from Canberra, London, Ottawa ...

During the credit crisis, investors sought safety not only in U.S. Treasuries but also in government bonds issued by other nations. In 2008 the Barclays Capital Global Treasury bond index -- which tracks issues of investment-grade countries, including Australia, Britain, and Canada -- rose in lockstep with U.S. Treasuries.

Yet those bonds didn't fall when U.S. Treasuries did. From the start of 2009 through mid-November, they rose more than 10%. And they yield more than U.S. Treasuries -- nearly two percentage points more in the case of 10-year Australian bonds. Invest via a diversified fund such as SPDR Barclays Capital International Treasury (BWX).

Another reason to go abroad: exchange rates. The dollar has been losing value against other currencies in part because foreign appetite for U.S. assets is waning. As long as the trend continues -- which looks likely -- you'll make money on foreign bond funds even if the bonds themselves go nowhere.

In addition, put 10% of your bond portfolio in debt issued by countries with emerging economies, using a fund such as Fidelity New Markets Income (FNMIX). While those bonds expose you to more credit risk, they're a hedge against inflation. The fortunes of many governments in Latin America and Asia are dependent on raw materials and commodities, whose prices tend to climb when inflation does.

Option 3: if you're okay taking on a bit more credit risk

Add high-quality munis and corporates to the mix

Unlike the federal government, municipalities have been known to default. But fewer than 0.1% of those whose debt was rated investment grade defaulted in the past decade.

Even in the recession-racked early 1980s, the rate rose to only about 1.5%. So credit risk isn't huge -- especially if you stick with high-grade issues in a diversified fund such as Vanguard Intermediate-Term Tax Exempt (VWITX).

And when you factor in that munis are free from federal tax, high-quality munis offer a better yield than Treasuries today. Normally munis pay about 80% of what Treasuries do; now AAA-rated munis are yielding more than 90%, on average. "That's a bargain," says George Strickland, portfolio manager with Thornburg Investment Management.

As for corporate bonds, the average intermediate-term fund holding them lost around 5% of its value in 2008, then rose more than 14% to mid-November 2009. If you own corporates as part of a diversified bond portfolio, they can actually reduce your potential exposure to losses.

If your bond portfolio contains nothing but Treasury funds, redeploying your money according to these model portfolios is easy enough.

But what if most of your fixed-income money is in a blended fund such as the Vanguard Total Bond Market index (VBMFX)? Check what it invests in. The Vanguard fund is typical: More than a third is in Treasury and U.S. agency bonds; nearly a third is in corporates and foreign bonds; the remainder is mostly in mortgage-backed securities.

It's perfectly reasonable to keep a large stake in that or a similar fund, as long as you use the rest of your fixed-income money to add munis and foreign bonds.

Either way, what you end up with may not be as "safe" as an all T-bond portfolio. But it will certainly be less volatile and should throw off appreciably more income to boot. Sounds like a pretty good tradeoff.  To top of page

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