It’s getting harder for investors to ignore the government’s massive borrowing needs. By Jeffrey R. Kosnett, Senior Editor January 20, 2010 Treasury bonds are showing signs of cracking. From late fall through mid January, the yield on the benchmark ten-year Treasury note jumped from 3.2% to 3.8%, a huge move by the standards of normally staid government bonds. Even with this run-up, though, Treasuries are still not great sources of current income. In fact, by historical standards, yields remain puny. As recently as July 2007, the ten-year Treasury yielded 5.2%. And you may remember a time, in 1981, when the ten-year note paid nearly 16%.Higher yields ahead. Recent action in the bond market is sending an important signal. That message, says David Glocke, who manages four Treasury funds for Vanguard, is that long-term rates are finally starting to rise toward a higher range. Glocke expects the ten-year Treasury to reach 4.4% by the end of 2010 and then hang around that level -- up a little, down a little. He says the bond market is already pricing in “a good three to four moves” by the Federal Reserve to raise short-term interest rates in 2010, a course that usually presages higher interest rates across the maturity spectrum. All of this suggests that 2010 could be another disappointing year for Treasury-bond investors. Last year, the ten-year Treasury produced a negative total return of 9.3% because interest rates rose as the financial crisis eased and investors became more willing to assume risk (bond prices move in the opposite direction of rates). If yields continue to rise, Treasury holders will lose money again (although it’s likely they won’t lose as much as they did in ’09). Still, if you have money in Treasury funds or own a ladder of T-bonds, you shouldn’t sell now. But I would take two steps: First, I’d remind myself to think about Treasuries in the same way I think about any other asset category that tends to move in cycles. Be ready to invest new money as rates work higher (and prices fall), using the same dollar-cost-averaging principle -- investing a little at a time at regular intervals -- that makes so much sense with a long-term stock portfolio. If you’re one of those rare -- and blessed -- people who bought a 30-year Treasury in 1980 yielding 12% and are now getting the principal back, you should buy a ten-year Treasury and accept its nearly 4% yield. I asked Glocke what he’d do if he were one of those bondholders who cashed in fat coupons for three decades and now needs to reinvest. He said he’d vote for Treasuries on “the shorter end of the curve,” meaning five to ten years. (Incidentally, if you have an actual bond certificate bearing a double-digit yield, frame it and hang it on your wall; you made an investment for the ages.) Advertisement The second thing I’d do is look beyond government debt. Normally, rising Treasury yields should result in higher yields for corporate and municipal bonds, as well as for mortgage securities. But these aren’t normal times, as you can see from the rest of the bond market since November. Yields of high- and medium-quality corporate bonds have barely budged, and yields of high-grade municipal bonds have actually dipped a bit. Those moves suggest that investors are focusing more on the strengthening economy and worrying less about questionable municipal and corporate finances. Municipals are doing well because tax-free bonds are scarce and because an improving economy should translate into healthier state and local finances. Meanwhile, it’s getting harder for investors to ignore the government’s massive borrowing needs, especially now that the Federal Reserve says it plans to terminate its program of buying long-term debt to keep mortgage rates low. Here’s the bottom line: High-grade corporate- and muni-bond funds, junk-bond funds, and all-in-one bond funds should outpace Treasury bonds and funds in 2010, as they did last year. That’s the message we’re getting from the edgy Treasury market.