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Be Wary of Bull Market in Bonds

Richard Widows

Bond mutual funds that invest in Treasuries led the pack in the third quarter as investors sought a safe haven from financial turmoil. But the direction of the economy and interest rates, not the current crisis, will determine if they're still worth buying.

Seven of the 10 best-performing bond mutual funds were long- and intermediate-term Treasury funds last quarter. The remaining three in the accompanying table are, technically, government bond funds. But the RidgeWorth U.S. Government Securities Fund(SCUSX Quote) and the SunAmerica U.S. Government Securities Fund(SGTAX Quote) are heavily weighted in Treasury notes and bonds. In addition, some top holdings of the California Investment Trust-U.S. Government Securities Fund(CAUSX Quote) are Treasury bonds.

Leveraged, "inverse" and institutional bond funds were not included in the tabulations of the adjoining top-ten bond fund list.

These Treasury and government bonds enjoyed gains in principal values as investors fled to safety as the credit crunch took its toll on the stock market. They enjoyed a tailwind of falling interest rates.

Now, expectations of an economic slowdown could help them even more. Bad news is everywhere -- sluggish automobile sales, rising joblessness and a slowdown in factory orders. In addition, there's talk of additional interest rate cuts by the Federal Reserve.

But a huge potential obstacle stands in the way of an extended bull market in bonds. A bailout of the financial sector could require the sale of hundreds of billions of dollars of Treasury notes and bonds. Dumping them on the market would depress prices and elevate yields. If this occurs, bond investors who wait for quotes to trough and yields to crest will enjoy a double-barreled gain from a subsequent rebound in prices and lower yields.

The key to investing in U.S. government and Treasury bonds is to approach the market with caution and gain confidence in your assessment of the economy and the impact of a bailout before jumping in.