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By Jason Stipp | 05-11-2010 11:41 AM

Pressure Points in Your Bond Portfolio

Morningstar's Eric Jacobson on the short- and longer-term drivers behind U.S. Treasuries and tactics for avoiding pitfalls in foreign bonds.

Jason Stipp: I'm Jason Stipp for Morningstar. With market turmoil spreading over the past few days, investors who had been flocking into fixed income over the last several months may be taking a closer look at their fixed income allocations, specifically Treasuries and their allocations to foreign bonds.

Here with me to offer some insight on those areas of the bond market is Morningstar's Eric Jacobson. He's director of fixed income analysis. Thanks for joining me, Eric.

Eric Jacobson: Glad to be with you.

Stipp: So the first question for you: On a day like today, when the markets are really suffering and we're seeing Treasuries have a lot of interest as safe-haven investments, a question for you on how investors should look at Treasuries.

We've been hearing for a long time leading up to this turmoil that Treasuries weren't going to be a good place to be because of the deficits and some of the questions around rising rates. But now everyone's going into Treasuries because there's uncertainty. How should I think about Treasuries, given these two potentially conflicting ideas out there?

Jacobson: It really does all go back to the basic premise that you mentioned, which is, are we in some sort of crisis or not? You pretty much do have to assume that whenever you have this kind of global instability, people are going to retreat to U.S. Treasuries. At least that's the way the world works today.

The other issue is that, a little bit more broadly, the fact is that the Treasury market has already priced in the expectation that yields are going to be higher in the future. Now it's very possible that as an individual investor you may not believe that the market has priced them in sufficiently, but the fact is that they are priced in. So, expectations built into the market for five years from now, for example, are that yields are going to be meaningfully higher across the entire yield curve.

If, however, you are one of the same people who believes that we are going in for a long period of economic despair, it's tough to make the case for those higher rates because as long as the system works as it does today, which is that people still rely on the United States as a refuge of safety, you can generally expect yields to remain flat or even fall potentially.

The only point at which that theoretically is likely to reverse itself is if somehow the rest of the bond market starts worrying so much about the United States that it feels comfortable hiding out somewhere else. Today, with the euro on watch, if you will, there don't really seem to be too many places like that.

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