How to prepare for rising Treasury rates, as if

We know how this is supposed to play out. Conventional wisdom says bond rates will rise, punishing investors in long-term securities as bond prices -- true to their inverse relationship with rates -- tumble. U.S. Treasuries, the most interest rate-sensitive segment of the bond market, will be hardest hit. Yet rates just keep falling. The euro zone's continued crawl toward resolving its debt crisis, coupled with disappointing jobs reports in the U.S., helped send the 10-year Treasury yield from 2.39 percent in March to a record low 1.47 percent in June. That translated into a 12.5 percent return over the past three months for the average long-term government fund tracked by Morningstar. Short-term government bond funds, meanwhile, delivered an average return below 1 percent. Warning Bells It's been a frustrating stretch for prudent bond investors girding for a rise in interest rates. The average one-year return for Morningstar's long-term government bond fund category is 32.7 percent. Yep, 32.7 percent. Over the same stretch, intermediate-term taxable bond funds rose 5.7 percent and long-term taxable funds gained nearly 12.2 percent. Stocks? Well, the top-performing Morningstar category, large-cap growth stock funds, rose 2.7 percent in the past year. So much for conventional wisdom. While it's hard to ignore recent performance, investment pros say now is not the time to cave and load up on bonds, especially long-term Treasuries. A recent research paper from Ibbotson Associates concluded that the next 20 years are not likely to yield a bond bonanza. "Formidable" stock returns The report's conclusions favor stock investing. Ibbotson forecasts that the S&P 500 stock index will return an average 7.6 percent, and long-term government bonds 4.1 percent. (Before you get too enamored with the idea of that 4.1 percent, consider that intermediate-term government bonds are expected to deliver 3.6 percent -- with about 80 percent less volatility.) Joseph Davis, head of Vanguard's Investment Strategy Group, also believes that future bond returns should be muted, while stock returns could be "formidable." Yet while he says many people believe we're headed for a 1950s scenario -- at which time bond yields began to rise from low levels and their returns dramatically lagged stocks for the next two decades -- he thinks investors should be aware of another scenario: In Japan, interest rates plummeted more than 10 years ago and have yet to budge. True to the Vanguard script, Davis advocates staying committed to a diversified portfolio of both asset classes. Playing Defense Chun Wang, a portfolio manager for multiple funds at the Leuthold Group, including the Leuthold Core Investment Fund, says long-term Treasury rates may fall even farther in the short term, but could rise after a resolution in Europe. “The 1.6 percent rate today could go to 2.25 or 2.50 percent quickly,” he says. “The upside from a short-term dip in rates from here isn't worth the downside risk of when rates rise.” For that reason, the 20 percent fixed-income portion of the Leuthold Group's Core Allocation fund is steering clear of Treasuries. It's focused on non-Treasury bonds with maturities between three and seven years. That includes high-grade corporate bonds and high-grade municipals, as well as mortgage-backed securities. “We are getting more income on an absolute basis than if we invested in Treasuries, without sacrificing credit quality,” says Wang. Because the Leuthold Group expects more volatility in the near term, high-yield corporate bonds are at a minimum in Wang's portfolio. “Right now we want to play defense with our bonds,” says Wang. Staying disciplined That could be a smart move. Money manager William Bernstein, an expert on asset allocation and author of "The Investor's Manifesto: Preparing for Prosperity, Armageddon and Everything In Between," has been warning of the damage rising rates will rain on unsuspecting bond investors, especially those who have longer-dated securities. He's not budging from his advice to stick with short-term (under five years) Treasuries and short-term high-grade corporate bonds. With today's low Treasury rates not even keeping pace with inflation, Bernstein says bond investors are looking at "an extreme low return/high risk proposition." One of the hardest things in investing is making a reasonable, disciplined decision and then being wrong for years after, says Bernstein. "Such was the case for sane equity investors in the '90s, who watched in horror as their uninformed neighbors got rich -- temporarily -- in tech stocks, while they sat in fuddy-duddy value stocks or cash or bonds," he says. "I think we're in a similar period now with bonds." --Bloomberg News--