Got the Treasury Bubble Blues?

You've probably heard the arguments by now. A quick hunt for the phrase "Treasury bubble" on Google's search engine serves up roughly 2 million results. Granted, that's not quite up to Britney Spears standards (90 million), but it does beat "collateralized debt obligation" (just less than 500,000) by a handy margin. Treasury bubble chatter got going in earnest in December--back when the yield on the 10-year note dropped close to 2% and three-month T-bills yielded next to nothing--and the concept isn't much more complicated than this: The rapidly worsening financial and economic crisis induced a panic that created a tidal wave of demand for the perceived safety of U.S. Treasuries. That demand pushed Treasury yields far below a level that many believe adequately compensates for their risks.

Although Treasury rates have already notched up from their December lows, whether they're due for an even sharper correction anytime soon is a hotly debated topic (starting with whether last year's Treasury rally could even qualify as a bubble at all). Some argue that the massive amount of cash the U.S. government will have to borrow to combat this economic beast, on top of an already huge budget deficit, will make Treasuries seem like less of a safe bet to our creditors at current low yields. Others proffer that low Treasury yields aren't such a bad thing in a deflationary environment. Meanwhile, those of a more economically optimistic persuasion--tongues clucking--point to the speed at which gobs of money fled riskier assets in late 2008 and argue that if and when investors get even the slightest inkling that the economy is on the mend, the result could be a staggering sell-off for Treasuries.

Unattractive at Almost Any Speed
Which of these scenarios will actually unfold is anyone's guess, but to get a better sense of the risks that these historically low yields pose to Treasury investors, it's worth doing the math. Take the Barclays Capital 10-Year U.S. Treasury Bellwether, which yielded 2.9% on Feb. 4 and has a duration of 8.5 years. Although gradual or sporadic rate shifts would alter the results, if the yield on that index rose suddenly to, say, 4.5% (a rate that accommodates modest expectations of 2.5% annual inflation and a 2% real return), it could theoretically suffer a percentage loss of around 14%. If the yield jumped as high as 5.5%, that loss would be greater than 20%. In the month of January alone, the index lost close to 5% as its yield climbed half a percentage point. Longer-maturity Treasuries felt even sharper pain: For instance,  Vanguard Long-Term U.S. Treasury (VUSTX), which has an average maturity of 16 years, has lost 8.4% so far in 2009.

That doesn't mean that those who own government-bond funds as the low-risk piece in a portfolio mix should run out and sell them, particularly if they offer a reasonable blend of Treasuries, straight agency debt, and agency-mortgage bonds. But it does mean that now would be a bad time to start buying them. Those counting on a repeat of last year's rally could be in for a surprise and possibly a nasty one at that.

Even if Treasury rates do remain low for some time, there are almost certainly better deals out there--even for investors only interested in taking a modicum of risk. After all, with short-term Treasuries yielding just a fraction of a percent, Treasury money market funds (including those at behemoths Vanguard and Fidelity) have been slamming their doors shut to avoid being forced to put more cash to work in an environment where it's a struggle finding enough income just to offset management fees.

To get a feel for the wide disparities in value in the market today, it's useful to compare prices on a trio of high-quality, short-term Barclays Capital indexes. The Barclays Capital U.S. Treasury 1-5 Year Index currently yields a little more than 1%, while the Barclays Capital U.S. Government/Credit Index (which stashes a little more than 40% in Treasuries and the rest in investment-grade corporate bonds and agency debt) yields 4%. The all-corporate index of comparable quality and maturity yields 6%. That yield advantage is particularly important for short-term bonds, because the typically limited potential for price appreciation (or depreciation) means that income makes up a much bigger component of total return.

There's no question that if you're looking to preserve principal above all else, non-Treasury money market funds (that are also low-cost, high-quality, and run by trustworthy shops), which currently offer yields ranging from 1%-1.5%, make as sturdy a mattress as any. It's also widely agreed that volatility will remain the rule, rather than the exception, across bond sectors in the year ahead. So, those turning to a bond mutual fund for a more compelling combination of safety and yield have to be willing to accept the possibility of more principal fluctuation than they may have been accustomed to in the past.

Sifting through the Ashes
Those caveats aside, it's really no surprise to see investors turning to short-term bond funds, many of which have seen sizable inflows in 2009. However, we can't ignore the unsettling fact that the short-term bond category (along with the much lamented ultrashort-bond pack) resembled a crime scene last year. Over the past decade, returns in this group were often tightly bunched, with the difference in annual total returns between the group's top and bottom deciles fluctuating between 1% and 3.5%. That gap blew out to a stunning 13% in 2008, and not because there was such a wide variety of ways to create a pleasing outcome for shareholders.

Not only did the majority of the group land in the red in 2008, but 22 out of 123 distinct offerings suffered double-digit drops. While funds could be forgiven for posting modest losses in an environment this challenging, the ones that went wrong went way wrong--whether caught off guard by the initial onslaught of deteriorating subprime loans, seduced by the "value trap" of structured bonds that appeared cheaper and cheaper (only to get cheaper still), or failing to maintain adequate diversification and liquidity in their portfolios--a profoundly disappointing result for shareholders who viewed these offerings as the safest components in their portfolios.

Still, short-term bond funds' track records over the past year are useful starting points for separating the wheat from the chaff. You wouldn't necessarily want to seek out 2008's top performers, because many of those hold sizable Treasury stakes, which, as we've described, may not represent the market's most compelling values. And while some of the bad apples in the group may yet rebound, we'd question whether loading up on the market's most troubled sectors--citing the wide gap between market prices and fundamental value as just cause--is an appropriate short-term bond strategy.

Fidelity is one example of a bond shop that got hit in the initial stages of the credit crisis by failing to appreciate the cliff that the market for subprime-mortgage bonds was about to fall over. But to the firm's credit, it got religion in early 2008 and cut back its funds' dicier holdings in an effort to bring volatility back in line with shareholders' expectations. That move prevented much more pain for both  Fidelity Short-Term Bond (FSHBX) and sibling  Fidelity Ultra-Short Bond  in the back half of the year. As manager Bill Irving (who runs  Fidelity Government Income (FGOVX), an Analyst Pick in the intermediate-government category) put it in a recent conversation, the team realized that when confidence and liquidity vanish from the market, "money good"--meaning that the bonds should continue to make good on their principal and interest payments over time--"is not good enough." We wholeheartedly agree.

Battle-Tested and Still Ready for Action
Some short-term bond funds have handled market turbulence like pros, and it's hard not to sit up and take notice. In particular, there are three funds that we've long liked in the category that we'd highlight as worthwhile options for investors seeking a better value in a still relatively low-risk package. Although these funds don't shy away from some areas of the market that were slammed in 2008--including asset-backed, nonagency mortgage, and midgrade corporate bonds--they've all held up reasonably well to very well in this downturn. While we don't know when investors' appetite for these riskier sectors will return, the following management teams have demonstrated their attentiveness to risk under trial-by-fire circumstances. Moreover, their straightforward approach--avoiding the market's more-esoteric bonds, derivatives, and leverage--takes a layer of mystery out of the process and makes the chance of a nasty surprise almost nil.

 T. Rowe Price Short-Term Bond (PRWBX)
This fund gained 1.2% last year when many funds with similar strategies landed in the red. The secret to its success is simple: Manager Ted Wiese keeps the fund well-diversified across individual sectors and issuers, avoids the more complex structured bonds that are more prone to bouts of illiquidity, and makes sure that the fund is compensated for the risks that it takes. Although the fund may take on more corporate credit risk than some rivals, Wiese's (and the firm's) shareholder-oriented mind-set should continue to help it avoid real trouble. In fact, this fund is so easy to recommend that we recently made it an Analyst Pick.

 Baird Short-Term Bond (BSBIX)
This small fund deserves more attention than it has gotten in its little more than four-year life. The main attraction here is the cohesive management team led by the firm's fixed-income head, Mary Ellen Stanek. Stanek has run bond money alongside comanagers Gary Elfe and Charlie Groeschell for 25 years. They've added three other managers and supporting personnel over the years to form a tightly knit group with good expertise across sectors. Like the T. Rowe Price team, we've been impressed with their careful consideration for shareholders' expectations, which has helped prevent the fund from getting tripped up in bolder bets made by some rivals.

 Vanguard Short-Term Investment-Grade (VFSTX)
This $19 billion fund needs no introduction. Even though it was the worst performer in this trio in 2008 (it lost 4.7% for the year), it attracted close to $700 million of new money in January. It typically sports a more credit-sensitive profile than many peers, of late stashing roughly 40% of the portfolio in midquality A and BBB rated corporate bonds. That said, we think that manager Bob Auwaerter, who has run the fund for more than 25 years, has the experience, judgment, and support to avoid serious credit-related problems in tough economic times to come. As market conditions thaw, this fund is positioned to benefit.

Senior mutual fund analyst Eric Jacobson contributed to this article.