Disastrous bond rout just up the road, experts warn

How's this for an investment opportunity: a guaranteed yield of 3.2 percent, with an enormous potential downside. As risky as that sounds, millions of investors are moving money into Treasury bonds as a "safe haven." In early September, the yield on the 30-year Treasury bond sank to a new low of 3.2 percent, while the 10-year note fell to 1.9 percent. If the inflation rate stays anywhere close to its current modest 3.6 percent pace, long-term investors will be guaranteed to lose money after factoring in inflation's toll. And that's only scratching the surface of the risks. Many savvy money managers are steering clear of the Treasury minefield. "I wouldn't lend money to anybody for 30 years at 3.2 percent, especially not the U.S. government," says Carl Kaufman, manager of the Osterweis Strategic Income Fund, which has delivered a peer-beating 7.3 percent annualized return over the past five years. Instead, Kaufman is loading up on short-term high-yield bonds such as that of discount retailer Dollar General, which yields in excess of 5 percent with a two-year maturity. The risk Kaufman and other managers are worried about is something most bond investors haven't had to deal with since the 1970s -- the prospect of a sustained rise in interest rates. When rates go up, bond prices fall as their yields are less attractive compared with new bonds issued at the higher rate. The longer the term, or maturity, of the bond, the greater the interest rate risk, because investors are locking in yields for a longer period of time. 'Scary Ride' With yields so low now, an inflationary shock of any sort would be devastating, as rates would spike in response. Ben Inker, director of asset allocation at GMO, a Boston money manager, calculated what the damages would be if, say, yields on Treasury bonds went up just three percentage points, driving prices down. The answer: a 23.5 percent loss for the 10-year Treasury and a 40.7 percent loss for the 30-year bond. While no one expects a big jump in inflation in the near term, "I see the likelihood of an inflationary shock as a high probability," says Thomas Atteberry, manager of the FPA New Income Fund, which has never had a losing year since its 1984 inception. Atteberry expects inflation to pick up in the next three to five years. It could come as an unpleasant surprise, as in 1974 when OPEC flexed its muscle and U.S. inflation topped 12 percent. It can also happen as a result of war. After Iraq invaded Kuwait, consumer prices rose at more than a 6 percent rate in the fall of 1990. Inflation also rises in less traumatic periods: It blipped above a 4 percent annual rate in the spring of 2006 and above 5 percent during the summer of 2008. Add onto that four or five percent inflation rate a small 'real rate' of interest, which investors typically demand, and you could be looking at 6 percent Treasury rates. Inker and GMO are well-known for their seven-year projections for asset classes, which have been very accurate. "Our expected return is that the 10-year Treasury note loses 1.3 percent a year after inflation," says Inker. With the likely returns for Treasuries so low, Inker believes that emerging-market stocks are actually less risky than Treasuries for long-term buy-and-hold investors. He predicts the best-performing sector will be emerging-market stocks, which have sold off sharply in 2011. He expects such stocks to produce annual inflation-adjusted returns of 6.5 percent. The downside is that they may be much more volatile in any given year. "Emerging-market stocks now have higher dividend yields than 10-year Treasury bonds and their earnings are growing," says Inker. "Over 10 years, the odds of emerging markets losing to Treasuries are very, very low. But it's going to be a scary ride." Hyperinflation Fears Why are investors willing to put up with such low yields? While conservative investors own Treasuries because of the guarantee of repayment and the liquidity of the Treasury market, many of the people buying Treasuries today aren't long-term investors. They're speculators and traders betting on a continued decline in America's fortunes. "There's a decent likelihood that Treasuries will be the best place to invest in coming months, but I'd be very worried about them as a long-term investment," says Rob Arnott, who oversees some $80 billion of asset allocation funds and accounts at Research Affiliates in Newport Beach, Calif. "The scenario in which they do well is the Japan scenario in which deflation emerges. The scenario in which they do horribly is even a modest uptick in inflation." Arnott isn't predicting just a modest uptick in inflation, however. Over the next 10 years, he thinks, there is a 50-50 chance the U.S. may enter a hyperinflationary environment like the 1970s when interest rates soared to the double digits. Because the U.S. national debt is so large, he predicts the Federal Reserve will try to inflate its way out of the problem by printing loads of dollars. Higher inflation would also debase the currency, making it easier for the U.S. to pay off what it owes the rest of the world. "The temptation to debase the currency and reduce the debt in that way will, politically, be too tempting to ignore," says Arnott. Should you sell all of your Treasury bonds and just invest in emerging-market stocks? Obviously not, as developing nations remain volatile. What's more, Arnott thinks the U.S. is entering a double-dip recession and that emerging markets will fall along with the U.S. market. A better strategy could be to sell Treasury bonds and hold cash, and then gradually increase an emerging-market stock allocation as the market falls, and dollar-cost-average into the stocks by buying into them at regular intervals. And if we do enter the deflationary Japan scenario? While it's true that Treasuries will do well, cash will make it so much easier for investors to sleep at night. --Bloomberg News--