From the February 2009 issue of Research Magazine • Subscribe!

'No Free Lunch' with Bonds

The Barclays Capital U.S. Aggregate Bond Index hits some bumps but did end 2008 up 5.24 percent.

After a strong first quarter start (+2.17 percent), the Barclays Capital U.S. Aggregate Bond Index fell 1.02 percent in the second quarter and followed that with a minus 0.48 percent return in the third quarter to stand at 0.68 percent through three quarters, explains Jeff Tjornehoj, research manager, U.S. & Canada, Thomson Reuters Lipper, Denver. This was followed by a strong rebound in the fourth quarter (+4.58 percent), so the group ended 2008 up 5.24 percent.

This rebound was largely due to the meltdown in equities and fears over banks, which has made "nearly everything look too risky," Tjornehoj says.

"Everything, that is, but good ol' Uncle Sam: His debt seemed the most immune to crisis and throughout the quarter the bid was in. Yields were pushed so low that talk of a Treasury bubble gained more currency as the days passed, possibly catching investors at the worst time imaginable."

Some Treasury bill yields did briefly turn negative in December, an event not seen since 1940, as fears mounted that the U.S. economy could be headed toward a deflationary period, the analyst points out.

General U.S. Treasury funds improved 15.55 percent in the fourth quarter. U.S. government funds also posted a solid quarter (+6.01 percent).

"Curiously, for all the talk of deflation that propelled Treasuries ahead, the Treasury Inflation-Protected Securities (TIPS) Funds group, which had its share of volatility during the year, zoomed ahead 5.61 percent in December, although ending the quarter down 3.91 percent," the analyst points out.

At the same time, government and agency funds trailed their Treasury counterparts and were passed up by the long end of the curve -- U.S. Government funds (+6.01 percent for the quarter) -- followed by intermediate U.S. Government funds (+4.58 percent), and short-term U.S. Government funds (+1.36 percent).

Now, there's talk of a $1 trillion to $2 trillion surge in government issuance to pay for financial sector bailouts and fiscal stimuli. "Should buyers balk -- and they might, given a choice between earning 2.70 percent in Treasuries (little upside potential for principal) or 3.40 percent on the S&P 500 (equities could stage a rally) -- yields stand a good chance of reversing course very quickly," says Tjornehoj. "Economists from JP Morgan and Merrill Lynch see the yield on the 10-year note touching 150 basis points to 165 basis points in the near term before anything substantial changes."

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