Which U.S. Treasuries Look Best for '06?

Intermediate-term securities look attractive

For people looking to invest in U.S. Treasuries in 2006, which ones look the best?

The answer, bond market observers say, is intermediate-term securities.

"If you're going to buy bonds, that's the place to be," said David Wyss, chief economist for Standard & Poor's.

Yields on short and intermediate-term Treasuries shouldn't move much over the course of the year because they're already discounting expected near-term interest rate hikes by the Federal Reserve, Wyss said.

But that's not the case with bonds with long maturities, according to Wyss, who sees yields for these securities rising, thus pushing their prices, which move in the opposite direction, lower. "Plus, you're really not getting any premium for the risk of holding a long-term security," he said.

Normally, long-term bonds carry a "risk/liquidity" premium that makes long-term rates average more than short-term rates, Wyss said in an economic forecast this month. In late December, however, the yield curve inverted.

Observers think the central bank will raise rates by a quarter-point two or at most three more times early in 2006 before ending its campaign to tighten monetary policy.

Mary Miller, director of the fixed income department at T. Rowe Price Funds, said intermediate-term Treasuries suffered the worst price erosion while the Fed increased rates over the last 18 months. Now that the bulk of its work appears done, however, "I think it's sort of safe to go back in the water," she said, referring to the asset class.

In the current interest rate scenario, investors buying intermediate-term Treasuries could capture about 97% of the return of the benchmark 10-year note without taking on the added risk that comes with long-term bonds, said Neil Burke, a member of the intermediate total return group at Loomis Sayles & Co.

"The market really isn't paying you for the longer maturities that are out there," said Burke, who oversees pension funds for the Boston-based money management firm. "So right now we would definitely say two-year to five-year Treasuries look pretty attractive."

A dissenting vote on intermediate-term Treasuries was cast by Rob Bloemker, who heads the mortgage and government securities team at Putnam Investments. He thinks investors would be better off holding a combination of short-term and 30-year Treasuries.

Bloemker bases his recommendation on his assessment of the economy, which he thinks is stronger than recent reports have indicated.

Those who view intermediate-term Treasuries as attractive think the economy will turn sour in the near term, especially as the housing market cools, Bloemker said. But "we haven't seen it roll over yet," he said of the sector, which he believes will stabilize rather than contract.

Aside from mutual bond funds, investors can also gain exposure to intermediate-term government bonds through two exchange-traded funds (ETFs) which purchase such securities: the $1.16-billion iShares Lehman 7-10 Year Treasury Bond Fund (IEF) and the $2.93-billion iShares Lehman Aggregate Bond Fund (AGG).

While iShares Lehman 7-10 Year is mandated to invest solely in U.S. Treasuries, iShares Lehman Aggregate invests across the broad spectrum of U.S. fixed income securities. It currently has about 37.9% exposure to government/agency securities, including 24.8% in U.S. Treasuries. (see ETF table below)

Here are the five best performing intermediate government mutual bond funds for the one-, three-, and five-year periods through the end of 2005:

One Year Through Dec. 30, 2005

FUND

RETURN (%)

EXPENSE RATIO

S&P STAR RANKING

ISI Total Return US Treasury Fund (TRUSX)

+3.7

0.69

4

Morgan Stanley US Govt Securities Trust/D (USGDX)

+3.6

0.59

5

JPMorgan Government Bond/Select (HLGAX)

+3.3

0.56

5

Van Kampen Government Securities Fund/A (ACGVX)

+3.1

1.03

4

Gartmore Government Bond/D (NAUGX)

+2.8

0.85

4

Three Year Through Dec. 30, 2005

FUND

RETURN (%) (annualized)

EXPENSE RATIO (%)

S&P STAR RANKING

JPMorgan Government Bond/Select (HLGAX)

+3.5

0.56

5

Dupree Mutual Fds:Intermediate Govt Bond (DPIGX)

+3.4

0.44

5

Goldman Sachs Government Income/Inst (GSOIX)

+3.4

0.58

5

Wells Fargo Advtg Govt Securities/I (SGVIX)

+3.2

0.50

5

Oppenheimer US Government Trust/Y (OUSYX)

+3.2

0.58

5

Five Years Through Dec. 30, 2005

FUND

RETURN (%) (annualized)

EXPENSE RATIO (%)

S&P STAR RANKING

BlackRock Government Income Fund/Inv A (CCGAX)

+6.2

0.98

4

DFA Invest Grp Intermediate Govt Fixed Income (DFIGX)

+6.2

0.17

4

American Century Target Maturity 2010/Inv (BTTNX)

+6.1

0.58

4

Wells Fargo Advtg Govt Securities/I (SGVIX)

+5.9

0.50

5

Vanguard Intm Term Treasury/Inv (VFITX)

+5.9

0.24

4

ETFs With Exposure to Intermediate-Term Government Bonds

ETF

1-YR. RETURN*

3-YR. RETURN(annualized

EXPENSE RATIO

iShares Lehman 7-10 Year Treasury Bond Fund (IEF)

+2.27%

+2.91%

0.15%

iShares Lehman Aggregate Bond Fund (AGG)

+2.16%

N.A.

0.20%

*Data thru 12/30/2005

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