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Amid Deflation, Pros Turn to Bonds




By Jeff Cox, CNBC.com Staff Writer

With investment advisors convinced the economy may be headed for a bout of deflation, they're turning to longer-term bonds for safety.

The uncertainty of the current environment creates a complicated picture for investors, but many advisors continue to feel comfortable with the safety of bonds, particularly those from the U.S. government and for a longer duration.

It's part of a mindset that believes inflation could well be the economy's long-term worry -- going out two, three or four years from now -- but in the near term prices could turn negative and bring about deflation.

"It's hard to see where the inflation is going to come from," says Brian Nick, investment strategist for Barclays Wealth in New York. "The longer-duration bonds look expensive but also look like stable, safe assets."

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Nick recommends investors target 7- to 10-year durations in bonds and Treasury notes, though some strategists are even backing the 30-year long bond.

Long-term bonds are a bad bet in an inflationary environment as their value erodes as costs go up.

But in deflation, they make attractive tools for investors who have the security of decent yields but also see increases in their face value and collect handsome coupon payments. Prices and yields move in opposite directions, with higher demand driving up prices and pushing down yields.

Government bonds had a remarkable July, with the yield on the benchmark 10-year note ending the month virtually unchanged even as the stock market roared higher by 7 percent. Stocks and bonds often move in opposite directions, as gains in riskier stocks dim the allure of safe-haven investments like government debt.

Nick recommends a barbell strategy, with longer-dated US Treasurys and triple-A rated sovereign notes from countries like Germany and Sweden on one end, and attractively valued equity holdings on the other. The middle would include investment-grade corporates, high-yield Treasurys, convertible bonds and defensive stocks.

"Equities are going to be tough to pick individually in a declining market... You want to be in our opinion looking at higher-quality fixed-income," says Steve Baffico, senior managing director at Claymore Securities in Chicago. "That brings you to things like corporate bonds, asset-backed securities, even into the high-yield market, where there's a degree of undervaluation and some pretty high-quality product that's mispriced."

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