The Miracle of Treasury-Bond Funds

You'll find only lumps of coal in your stock funds this year-end. But some bond funds squeezed out diamonds in the rough market. Any positive return is worthy of praise.

With panicked investors buying Treasury bonds as if they were the last Wii systems in the store on Christmas Eve, funds that focused on U.S. government debt stood out among 2008's top performers. On average, medium-maturity government-bond funds gained 5% in 2008. The reason: A mania for absolute safety -- the Treasury won't default -- has driven yields to record lows. Ten-year Treasury notes recently paid a measly 2.08%. Short-term bills hit 0%.

Under normal circumstances, such low yields would scream danger, as just a slight rise in interest rates or inflation would cause a hefty loss in Treasury-bond principal values. But some bond managers are now convinced the market situation is going to remain anything but normal. "We're getting close to a Japan-like environment of the '90s and early '00s," says Ken Volpert, head of the taxable bond group at Vanguard.

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He predicts little to no inflation (and possible deflation) for the next couple of years, and low interest rates for the next five to ten. In fact, on December 16, the Federal Reserve cut short-term bank lending rates from 1% to 0% to 0.25%.

Champions of safety will continue to benefit if Volpert proves prescient. The T. Rowe Price U.S. Treasury Intermediate (symbol PRTIX) and Vanguard Intermediate-Term Treasury (VFITX) funds top the Morningstar category of medium-maturity Treasury funds. In 2008 through December 19, they returned 14.8% and 14%, respectively, beating their peers by ten and nine percentage points, on average. Both have 30-day yields of less than 2.5%. Their respective expense ratios are 0.54% and 0.26%.

Both funds own only what T. Rowe Price manager Brian Brennan calls "the gold standard" of bonds. Each recently had about 85% of its assets in regular Treasury debt or Treasury inflation-protected securities.

The T. Rowe Price fund had the rest of its assets in Ginnie Mae securities, which are backed by the full faith and credit of the government. Vanguard manager David Glocke rounds out his fund's portfolio with federal-agency securities, as well as mortgage-backed bonds from Fannie Mae and Freddie Mac. Those are now under government conservatorship, so their debt counts as the closest possible thing to genuine government securities.

Volpert's Vanguard Intermediate-Term Bond Index (VBIIX) fund was a strong performer among medium-maturity general-bond funds. It ranked in the top quintile of its category and returned 4.7% in 2008 through December 19, beating its peers by ten percentage points, on average. Tracking the Lehman five- to ten-year U.S. Government/Credit index, it recently had 54% of assets in government bonds -- 42% in Treasuries and 12% in agency securities -- and the rest in investment-grade corporate bonds. Its recent 30-day yield was 4.72%, and its expense ratio is just 0.18%.

But what if rates do go up? T. Rowe Price New Income (PRCIX) fund manager Dan Shackelford expects higher long-term rates in a year. He says the Fed's latest rate cut will help "speed the economic healing process" and ultimately embolden investors. "As investors move out of the safe harbor of Treasuries, you have to make allowance for slightly higher rates," says Shackelford.

Rising rates will bring leaden losses for Treasury-bond funds. For example, T. Rowe Price U.S. Treasury Intermediate fund's average duration -- a measure of its sensitivity to changing interest rates -- recently stood at 5.5. That means if rates rise one percentage point, the fund will lose about 5.5% of its value. The Vanguard Intermediate-Term Treasury fund's average duration was recently 5.25. New Income's was 3.95.

To prepare his fund for rising rates -- the likely result of an economic upturn -- Shackelford is dipping the fund into slightly riskier waters. The fund's Treasury weighting is only in the high single digits now, down from close to 20% in mid 2007. "The price for safety right now is at an extreme," says the manager. "For the first time probably in five or six years, the compensation for taking risk is extraordinary."

Shackelford is thus buying the new FDIC-insured short-term notes of Citigroup and Goldman Sachs, which are guaranteed at least three years and recently yielded in the 2% to 3% range -- much higher than government debt of the same maturity. Then, for even more yield, he's buying blue-chip issuers' new bonds as they decide to borrow after an interruption in new supplies. An example: new ten-year bonds yielding about 7% from Caterpillar, which is rated A by Standard & Poor's and A2 by Moody's.

The New Income fund did well in 2008 by breaking even through December 19. It recently yielded 4.76%, and it charges a 0.64% expense ratio. If you are less scared than the typical bond buyer of 2008, it's a fine choice for a diversified sweep of bonds.