Reader: Do you agree that interest rates on T-bonds will be rising soon ? And why would it rise ? Is it because of the shear volume of bonds being issued to raise capital for the bailouts ? With this in mind would you consider trimming back on T-bond funds, especially long-term, and possibly buying more TIPS ?

Rick

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funds-newsletter: As you may know, I have been quite positive on bonds for a while lately, emphasizing high quality bond funds, with only a relatively small allocation to inflation protected bonds (TIPS). Going back to our 4th Qtr. '07 Newsletter (see it), I started recommending a 30% allocation to bonds for moderate risk investors, and have maintained or increased the allocation since.

The high bond allocation has proven very advantageous since any money held in bonds has performed far better than instead having put that money into stocks, or alternatively, into cash. And especially Treasury bond funds have continued to have positive returns. Normally, during recessionary periods, Treasury securities should be expected to do quite well. For example, between Oct. 1, '07 and Sept. 30, '08, here are the 1 yr. returns of some of the funds I frequently recommended:

Vanguard Short-Treasury  6.8%
Vanguard Interm-Treasury 9.8
Vanguard Long-Treasury 10.0
Vanguard Inflat Protected   6.2

But your question, apparently reflecting the article you read, suggests that Treasury securities (of all sizes) will underperform. While I am very reluctant to presume I can anticipate where interest rates will be headed in the future, I have doubts that the thesis you cite will turn out to be correct, esp. as applied to investing over the next year or so.

As stated above, Treasury securities usually increase in price during recessions as the Fed lowers short-term interest rates. It is now expected that the Fed will likely drop rates still more, although the lowest they can go is 0% and that is only 1% point below where rates are now.

However, the Fed's cutting of rates directly affects only short-term rates. Long-term rates are mainly affected by inflationary expectations. Usually, if short-term rates drop, it makes sense that long-term rates drop at least somewhat as well. When we are in a recessionary period, there is usually less of a strain on inflation. (Witness the huge drop in oil and other commodity prices now.)

So, other things being equal, I would not expect long-term interest rates to rise soon. If they did, it would likely be because investors were beginning to see the end of the recession in sight, perhaps 4 to 6 months ahead of its actual end. If the recession were likely to end by the latter part of 2009, investors would begin to anticipate growth returning to the economy and a resulting need for the Fed to raise interest rates off of their extreme current lows.

But will the extreme amount of borrowing by the Fed, as a result of the financial crisis, cause inflationary expectations to increase? And will the government be forced to raise the interest it pays on Treasury bonds in order to attract even more buyers, many of whom are foreigners? While I don't know the answer, I have my doubts.

One thing the government cannot afford to have happen is for long-term rates go up significantly. The housing crisis, which is at the root of the financial meltdown, must be turned around before the financial crisis can end. If long interest rates rise significantly in the near future, the result will be that mortgage rates will go up; this will hurt the housing crisis even more. (And what about autos and other big ticket items, since consumers and small businesses need affordable rates in order to make the kinds of purchases that will re-stimulate the economy?) Thus, it seems that the government will do everything in its power to keep long rates as low as possible.

Aside from cutting short-term rates, I understand that the government can consider buying L-T Treasury bonds outright to keep these rates down - more demand for bonds would result in higher prices and lower long-term rates. The Fed was considering doing this during the 2000-2003 period but never implemented it. (Perhaps our new columnist, Steve Shefler, may be able to address this possibility in upcoming Newsletters with more knowledge than I.)

The other factor relating to your question has to do with whether TIPS will prove to be a wise investment because of incipient inflation. Of course, inflation may eventually rear its head at some point. But so long as we are in the current crisis, which I suspect will be quite a while, I again have my doubts that this will occur. In fact, just the opposite as now acknowledged by central banks around the world reversing their former inflation-worried stances and now totally concerned about weak growth, not inflation.

And, even more telling, there is considerable worry about deflation. With consumer demand falling sharply, prices could even drop to the point of being lower than they were on a year-over-year basis. So when anyone suggests that inflation may rise to 7% or more over the next decade, as the article you sent me does, I would have to take most of what he says as, likely, off-base.

Since early March, prices for a typical TIPS fund such as Vanguard's have dropped about 17%! (without taking in account dividends) Over that same period, Vanguard's L-T Treasury has dropped a mere 3%. What this tells me is that investors do not see inflation as important, at least over the short term. And in fact, such investors are projecting that inflation will accelerate at less than 1% over the next 10 years!

This does suggest that most investors have probably gone overboard in expecting extremely mild inflation that will prove very unlikely to be that low. It also suggests that TIPS, purchased now, are likely to be a better investment than 10 yr. Treasuries over a 10 yr. holding period. (Better, though, does not necessarily mean TIPS will be a great investment; if interest rates rise over the decade, even TIPS may show poor returns while still "better" than regular Treasuries.)

However, the above facts would seem to support the idea that over the next year or so at least, we have little to worry about on the inflation front. If inflation does start to be a problem, say after the next year or two, that is when I would consider going back into TIPS in a bigger way.

I would continue to emphasize Intermediate Term Treasuries as shown in my current Model Portfolio (see the Oct. '08 Newsletter).

Thank you for the thought provoking question.