Uncle Sam’s IOUs may have enjoyed a recent rally, but other dividend-paying investments are offering far more attractive yields. By Jeffrey R. Kosnett, Senior Editor June 21, 2011 Editor's Note: This story has been updated since its original publication in the August issue of Kiplinger's Personal Finance magazine. After 318 members of the House of Representatives voted in May against raising the nation’s debt ceiling, effectively declaring that they had no problem with the Treasury stiffing America’s creditors, the yield on ten-year government bonds fell from 3.05% to 2.96%. Just six weeks earlier, it had been 3.59%. As of June 21, with the August 2 deadline for the debt ceiling getting ever closer, the yield remains below 3%. A whisper of default in any other nation would send government-bond yields into orbit. But in the U.S., yields drop. There can be two possible explanations for bonds’ bizarre behavior: Either the U.S. is so exceptional as to be exempt from ordinary bond-market nervousness, or the world’s investors, including foreign governments, are still not overly worried about debt-limit brinksmanship and remain way more concerned about the flagging economic recovery. Sponsored Content Since April, when it became clear that the U.S. economy had hit a wall, the bond market’s tone has shifted perceptibly. Before then, the conventional wisdom held that Treasury yields were irrationally low. Enormous borrowing, the end of the Federal Reserve’s QE2 (for “quantitative easing”) bond-buying initiative and supposedly rising inflation would drive ten-year bond yields past 4% late this year and to 5%, maybe even 6%, in 2012. Advertisement Staying Low Now, the thinking is that ten-year Treasury yields are stuck in low-3% territory until investors see signs that the economic expansion is no longer backtracking. The recent drop in yields “is a function of the soft patch in the economy,” says Richard Saperstein, managing partner of Treasury Partners, a New York City advisory firm. Saperstein expects rates to stay low well into 2012. He’s not alone: Few forecasters, including Kiplinger’s, believe 10-year Treasury yields will move much for the rest of this year. (See Kiplinger’s Economic Outlook for Interest Rates.) Nor will the debt-limit impasse cause a spike in bond yields. High jinks of this sort on Capitol Hill have happened before. In June 2002, the U.S. came within one day of breaching the debt ceiling. Congress, after much procedural wrangling and debate, voted to raise the ceiling just in time and sent the measure to President Bush, who had urged Congress for months to raise the limit or risk irreparable damage to the Treasury’s worldwide reputation for soundness -- much like President Obama and Federal Reserve Chairman Ben Bernanke are doing today. With relief, Bush signed the bill; the Treasury went on paying interest and issuing bonds; and Treasury prices and yields barely budged. Expect the same outcome this year, though with way more media hype and political fireworks. (The debt ceiling issue is more worrying for columnist Steven Goldberg; for his views, see VALUE ADDED: Washington's Debt Ceiling Showdown Could Be Big Trouble for Investors.) Once the debt-ceiling increase is enacted, you can then return your attention to the tug of war that will determine the future of bond-market interest rates. On one side of the clash are those who cite the four G’s -- gold, gasoline, groceries and the government’s budget deficit -- as reasons that higher inflation and, by extension, higher interest rates are inevitable. On the surface, bears (bears because bond prices fall when yields rise) have a good case: Kiplinger’s forecasts a 3% rise in consumer prices in 2011. Normally, 3% inflation implies long-term Treasury yields of 6% because bondholders expect some real gain after inflation and taxes. Advertisement But those on the other side of the rope aren’t letting go. The bond bulls are pessimistic on the economy. They see slackening growth, high unemployment, weak demand for credit, problems in Europe and moderation in the breakneck growth of Brazil and China. Oil prices, generally identified as a cause for higher inflation, are down 20% from their peaks. All of this, plus the stock market’s recent pattern of sharp ups and downs, encourages investors to buy Treasuries despite their low yields. Larry Swedroe, director of research for Buckingham Asset Management, in St. Louis, says that buyers of Treasuries are more tolerant of low yields than other investors because they see the lost income as the cost of “insurance” against economic distress and panic-selling of stocks and other risky assets. Just because Treasuries have been rallying, however, doesn’t mean you should buy them today. Rather, “this is a good time to sell,” says Matt Webber, senior portfolio manager for Bank of the West, in Los Angeles. Forget about all that big-picture stuff. The key, says Webber, is that a lot of interest-or-dividend-paying investments are more attractive, both for income and safety. “California general-obligation municipal bonds are paying 4% for ten years, tax-free,” he says. Munis, in general, are extremely cheap relative to Treasuries, he adds. The talk about a municipal bond solvency crisis is overdone. Also attractive are dividend-paying stocks, conservative real estate investment trusts and much else. Once the economy gets its groove back, you’ll be glad you passed on Uncle Sam’s IOUs at today’s unrewarding yields.