The Treasury Bond Bubble: A Survival Guide for Investors

Concerns have been escalating lately about the possible risks of investing in Treasury bonds. Just how bad is that risk, and what should investors do about it?

The most ominous warning came from Tobias M. Levkovich, U.S. equity strategist at Citigroup. In a note to clients on Monday, Levovich said he had found a "startling" correlation between equity returns in the period from 1990 to 2005 and Treasury bonds since 2000.

"It would suggest that the tremendous money flows into bond funds could end with similar losses to that which transpired for equity investors who poured cash excessively into stock funds back in 2000," Levkovich wrote. He was referring, of course, to the dot-com crash, when the Nasdaq index declined 46% from September 2000 to January 2001.

Rates Can Only Go Up From Here

Writing in The Wall Street Journal on Tuesday, Jeremy Siegel, a finance professor at the University of Pennsylvania, and Jeremy Schwartz, director of research at WisdomTree, a sponsor of exchange-traded funds, warned that investors in bond funds are "courting disaster," and made the same comparison to the 2000 tech-stock bubble.

Siegel and Schwartz said that if 10-year Treasury bond rates, now at 2.8%, rise to 4%, the capital loss on bonds will be more than three times the current yield. They said there was no doubt that interest rates would rise as government programs to care for the baby boomer generation kick into gear.

So what's an investor with a bond portfolio heavily invested in Treasurys, which have the cachet of being the world's safest investment, supposed to do now? Some investment advisers recommend coming up with a long-term iplan and sticking to it despite the marketplace's short-term ups and downs.

Consider Good-Quality Corporate Bonds

But even with a long-term strategy in place, investors can tweak their portfolio to avoid a potential disaster.

Marilyn Cohen is a fund manager at Envision Capital Management, a Los Angles fixed-income investment management company, and the author of Bonds Now!, a bestselling guide to bond investing. She urges investors with large investments in Treasury bond funds to "take some or all of your gains off the table."

Instead of government debt, she says, investors should buy individual bonds, mainly corporate bonds rated BBB+ and above, which she says have a decent "spread," or a positive interest rate difference, over Treasury bonds.

By buying individual bonds, she says, investors can lock in maturity and yield, and can avoid the problem in some bond funds of a declining dividend caused by investors stampeding into the funds, forcing the fund managers to buy lower-yielding securities.

"I would stay out of the Treasury market because the yields are too painfully low, and I would be very selective in buying good-quality corporate bonds, which are in an unbelievable sweet spot," Cohen says.

Shorten Your "Duration Risk"

Admitting it's a bit of "blasphemy for a bond fund manager," Cohen also likes high-yielding stocks like Altria (MO) and Bristol Meyers Squibb (BMY). "If you compare some of these high-dividend-yielding stocks, to the 10-year Treasury bond, the stocks beat them by a mile," she says. They also tend to go down less in a downturn than other equities, she says.

Another investment approach is outlined by William J. Bernstein, author of The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything In Between.

Bernstein, a medical doctor who studies economic history as a hobby, agrees with Cohen that investors should exit Treasury bond funds as soon as possible and hold individual bonds. But he says investing in corporate bonds is a mistake because even with the highest-rated corporates, over the long haul the return isn't much more than 0.5% above Treasurys of similar duration. "That extra return is just not worth the risk," Bernstein says.

While Bernstein recommends sticking with government securities, he suggests that investors who are invested in Treasury or corporate bond funds shorten their "duration risk." "If your fund has an average duration of more than three years, I would exchange that for a fund that has a shorter duration," he says.

He notes that if you own a one-year Treasury and interest rates suddenly spike upward, you can roll over the bond within a relatively short period of time. While interest rates in short-term Treasuries are near zero, "if you do get a dramatic rise in rates and fall in prices, that zero return is going to look pretty good." That's because when interest rates go up, the value of existing bonds goes down, and they're worth less when sold on the secondary market.

What should investors who own Treasurys for income do now that rates are so low? Says Bernstein: "That person is going to have to suck it up. Chasing yield is one of the most dangerous things you can do."