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WEEKEND INVESTOR

January 14, 2012

The Rally That Wouldn't Die!

Treasury Bonds Have Been on a 30-Year Tear. Whether or Not the Party Can Last Is Beside the PointThere Are Far Better Places to Put Your Money
By JOE LIGHT and BEN LEVISOHN

At least one fear gauge shows that investors were more scared in 2011 than in the dark days of 2008. According to investment-research firm Morningstar , a portfolio of U.S. Treasurys with an average maturity of 20 yearsthe quintessential safe havenrose 28% last year, even better than its 26% jump in 2008. You would have to go back to 1995 to find a better year. More confusing still: Last year's surge came in the 30th year of a historic rally. Since 1981, long-term Treasury bonds have returned 11.03% annually, 0.05 percentage point better than the Standard & Poor's 500-stock index. Many big investors called an end to the bull last yearand suffered for it. Just ask Bill Gross, whose Pimco Total Return fund gained just 4.16% in 2011, about 1.7 percentage point below its peer average, after Mr. Gross bet heavily against Treasurys. But why take a chance when there are plenty of cheaper, higheryielding alternatives? For a safe place to stash cash, investors can tap other savings vehicles that have similar protections. And for investors looking for higher returns, many different types of bonds seem cheap now, strategists say, with better yields and only slightly more risk.
Treasury traders in Chicago last year.
Getty Images

"Although we don't think there will be much pain in Treasurys, there are simply better places to be," says Guy LeBas, chief fixed income strategist at investment bank Janney Montgomery Scott.

Economic Concerns
The European crisis and domestic economic concerns have pushed 10-year Treasury yields, which move in the opposite direction of price, to about 1.86% now from about 3.3% at the beginning of 2011, as investors flocked to safety. But a repeat of Treasurys' 2011 performance seems unlikely, experts say. To match last year's price rally, the 10year note's yield would have to drop to about 1.05%, far below its record low of 1.72% last September. At the same time, any number of factors could push yields sharply higherand torpedo

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Treasury bond prices. This month, the U.S. Labor Department reported that the unemployment rate continued to drop in December, hitting 8.5%, a sign that the labor market is getting stronger. An improving economy might tempt investors to take more risk and step away from relatively risk-free Treasury bonds. For investors who merely want to buy bonds and hold them to maturity, to collect the interest, the bigger risk is that interest rates remain below the rate of inflation, thus eroding returns. Already, with inflation clocking in at 3.4% in November, the latest data available, investors who buy 10-year Treasurys today and hold them to maturity would lose about 1.5% annually. Treasury yields can stay below the inflation Bloomberg News rate for long periods. From 1942 through 1951, the U.S. Treasury Department essentially forced the Federal Reserve to keep 10-year interest rates below 3%, as the country sought to pay off massive debt accumulated during World War II. Investors during the period would have lost 4.5% annually after inflation by investing in a portfolio of Treasurys with an average maturity of five years, according to Morningstar data. Nowadays, some strategists say the Fed's many rounds of bond buying, known as quantitative easing, are similarly keeping Treasury rates artificially low. In addition, new rules passed in the U.S. and Europe are forcing banks to keep a larger portion of their assets in low-risk securities such as government bonds, artificially boosting demand and driving yields down. Different investors use bonds for different reasons. Some want a pot of money that almost never loses value and is available in a pinch. Others want to build an income stream for retirement or use Treasurys to protect against potential stock-market plunges. Depending on your goals, there are steps you can take to find returns if yields stay low for yearswhile insulating yourself from a sudden rise.

Use 1: As a Safe Haven

Investors have long used Treasury bonds as a redoubt during times of economic turmoil. The bonds are easy to buy and sell in large quantities, and their U.S. government backing is about as strong an insurance policy as you can get. Such safety and liquidity come at a price. In the midst of the financial crisis, Warren Buffett famously sold $5 million of Treasury bills, due to mature four months later, for $5,000,090.70meaning the buyer was willing to lose $90.70 to ensure he wouldn't lose even more. Now, while the yield of three-month Treasury bills isn't negative, it stands at a paltry 0.02%.

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Topping Treasurys
Depending on how you use Treasury bonds, there might be better alternatives. For safety: Money-market accounts: government-backed, liquid, and easy to set up. I Series Savings bonds: 3.06% interest, keeps up with inflation, but can't cash out for a year. For yield: Ginnie Mae mortgage-backed securities: government-backed, yields of more than 3%. Emerging-market sovereign bonds: Superior yields, strong government balance sheets, but carry more risk. For diversification: Keep about 40% of your bonds in Treasurys, but try to buy more when yields pass 2.5% and sell when they dip below 1.75%. (Source: WSJ research)

Investors who don't need immediate access to their cash could buy a one-year certificate of deposit, which currently averages 0.77%, according to BankRate.com, and pick up an additional 0.67 percentage point of yield over that of a one-year Treasury. Certificates of deposit are usually backed up to $250,000 by the government, through the Federal Deposit Insurance Corp. Even in an emergency, the investor can unwind the CD and pay a penalty typically equal to just a few months of interest, according to Greg McBride, senior financial analyst at BankRate. Banks can, however, refuse to allow early withdrawal, he says. Another option: The Treasury Department also backs I Series savings bonds, whose interest rates adjust every six months for inflation and now yield 3.06%. Keep in mind that you can't buy more than $10,000 of the bonds a year, and won't be able to withdraw the money in the first year.

If liquidity is an issue, money-market accounts can be a good alternative. They also are backed by the FDIC, up to $250,000, and have an average yield of 0.45%, according to Bankrate.com. That is much better than money-market mutual funds, which don't have FDIC backing and right now yield 0.02% on average, according to iMoneyNet. Whatever you do, avoid long-term Treasury bonds, experts say, because their value can fall sharply if interest rates rise. The SPDR Barclays Capital Long-Term Treasury exchange-traded fund, which invests in Treasurys with maturity dates between 10 and 30 years away, dropped 13.1% in 2009, when investors piled back into the stock market and pruned their bond holdings, according to Morningstarnot the kind of return investors want from their "safe" assets. "The reason you hold riskless assets is to sleep at night and to have liquidity. It's not money you can take a haircut on," says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.

Use 2: Yield
Low rates have hit income-oriented investors, who buy bonds with the intention of holding them until maturity and collecting the yield, particularly hard. Many such investors use "ladders" of individual bonds that mature at one-year intervals, so they can roll over maturing bonds into higher-yielding ones if rates rise. If someone in 1990 had used such a strategy with a $1 million portfolio of 10-year Treasury bonds, he would have generated about $59,000 in income. Today, because yields have fallen so low, that same portfolio would generate only about $37,000. To do better, investors must take on some riskby buying bonds with longer maturities, lower credit ratings or both, says Michael Brandes, head of global fixed-income strategy at Citi Private Bank. Investors can get more yieldwith only slightly more riskvia non-Treasury government-backed bonds such as those issued by agencies or supported by agency mortgage-backed securities, says Justin Hoogendoorn, managing director at BMO Capital Markets.

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Mortgage-backed securities supported by Ginnie Mae, which guarantees investments backed by federally insured loans, carry the full faith and credit of the U.S. government and offer a higher yield than comparable Treasury bonds, he says. The Vanguard GNMA fund, which invests in government mortgage-backed securities, offers a yield of about 3.2%. What's more, if the Fed starts a third round of quantitative easing, there is a good chance it will target mortgages, which would send the prices of mortgage bonds higher, says David Ader, head of government bond strategy at CRT Capital Group. Investors should also consider bonds from less-well-known government agencies, says Brent Burns, president of financial adviser Asset Dedication, including Federal Farm Credit, the Tennessee Valley Authority and the Federal Judiciary Office Building Trust, which remodels courthouses. These bonds offer yields of about 2.6% for a 10-year maturity, more than 0.6 percentage point more than the equivalent Treasury. Another opportunity: emerging-market sovereign bonds. Even though these are often considered risky, many such countries carry much less debt than their developed market counterparts, notes Adrian Miller, a global market strategist at Miller Tabak Roberts Securities. U.S. investors should focus on investment-grade emerging-market bonds like those from Brazil or Mexico, says Luz Padilla, portfolio manager of the DoubleLine Emerging Markets Fixed Income fund. She recommends investors ignore bonds issued in local currencies and stick with those issued in dollars, because such plays pick up some of the safe-haven characteristics of the U.S. dollar while continuing to provide above-average yields. The simplest way to gain exposure to emerging market bonds is with an exchange-traded fund like iShares JPMorgan Emerging Markets Bond or PowerShares Emerging Markets Sovereign Debt , which yield 4.89% and 5.49%, respectively, and have weighted average maturities of 11.7 years and 14.8 years.

Use 3: As a Portfolio Diversifier

Treasurys might be irreplaceable in one area: as a portfolio diversifier. In 2011, large-cap stocks gained only 2.1%, while small-cap and international stocks lost 4.2% and 6.6%, respectively. On the other hand, an ETF tracking the Barclays Aggregate Bond index gained more than 7.5%, helped in large part by its 42% helping of U.S. government bonds. That is because Treasurys had a negative correlation with stocks last year, meaning they tended to rise when stocks fellmaking them a good way to reduce an investment portfolio's overall volatility. Some caveats are in order. To get the most diversification, investors would need to buy the longest maturities, because those see the most extreme price swings during periods of stress. The SPDR Barclays Capital Long-Term Treasury ETF gained 19% during August and September, when the S&P 500 lost 12.1%, according to FactSet Research Systems data, while the SPDR Barclays Capital Intermediate-Term Treasury ETF gained just 2.2%. Yet long-term Treasurys also are the first to get whacked when interest rates and inflation tick up. Still, investors have few choices when it comes to finding assets that move up when everything else is falling, says Michael Gavin, international macro strategist at Barclays Capital. "Treasurys may not always be a safe haven," Mr. Gavin says. "But for now, there are no natural alternatives."

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A version of this article appeared Jan. 14, 2012, on page B7 in some U.S. editions of The Wall Street Journal, with the headline: The Rally That Wouldn't Die!.

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