Amid Deflation Worries, Pros Turning to Long-Term Bonds

A deflationary environment has advisors looking toward longer-dated fixed income.

Investors going longer even as inflation remains the longer-term worry.

With investment advisors convinced the economy may be headed for a bout of deflation, they're turning to longer-term bonds for safety.

The uncertainty of the current environment creates a complicated picture for investors, but many advisors continue to feel comfortable with the safety of bonds, particularly those from the US government and for a longer duration.

It's part of a mindset that believes inflation could well be the economy's long-term worry—going out two, three or four years from now—but in the near term prices could turn negative and bring about deflation.

"It's hard to see where the inflation is going to come from," says Brian Nick, investment strategist for Barclays Wealth in New York. "The longer-duration bonds look expensive but also look like stable, safe assets."

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Nick recommends investors target 7- to 10-year durations in bonds and Treasury notes, though some strategists are even backing the 30-year long bond.

Long-term bonds are a bad bet in an inflationary environment as their value erodes as costs go up.

But in deflation, they make attractive tools for investors who have the security of decent yields but also see increases in their face value and collect handsome coupon payments. Prices and yields move in opposite directions, with higher demand driving up prices and pushing down yields.

Government bonds had a remarkable July, with the yield on the benchmark 10-year note ending the month virtually unchanged even as the stock market roared higher by 7 percent. Stocks and bonds often move in opposite directions as risk dims the allure of safe-haven investments like government debt, so a stronger stock market would drive yields higher

Nick recommends a barbell strategy, with longer-dated US Treasurys and triple-A rated sovereign notes from companies like Germany and Sweden on one end, and attractively valued equity holdings on the other. The middle would include investment-grade corporates, high-yield Treasurys, convertible bonds and defensive stocks.

"Equities are going to be tough to pick individually in a declining market...You want to be in our opinion looking at higher-quality fixed-income," says Steve Baffico, senior managing director at Claymore Securities in Chicago. "That brings you to things like corporate bonds, asset-backed securities, even into the high-yield market, where there's a degree of undervaluation and some pretty high-quality product that's mispriced."

As with the question of whether the economy will enter a double-dip, the situation with deflation may be as much perception as reality.

Analysts say the economy may not actually meet the dictionary definition of a double-dip, though it will still feel like one. The same may be true for deflation, defined as a drop in prices often due to a decrease in money supply.

The Consumer Price Index has declined for three straight months but is up 1.1 percent for the 12-month period ended June 2010. And inflation slipped to 1.05 percent in June but trended above 2 percent for the preceding five months, according to the Bureau of Labor Statistics.

"This is a little bit trickier than going out to the long end of the curve, because we could see some sort of implosion in the Treasury market." -Peak Theories Research, Abigail Doolittle

"A base case could be made for generally improving growth and moderate inflation. From an investment perspective, long-term assets such as long-term Treasury equities, corporate bonds and structured products are relatively attractively valued," says Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, N.J. "A diversified portfolio among these longer-term assets is going to offer some protection against deflation."

But with a $13 trillion debt looming and about $1.8 trillion on corporate balance sheets, the timetable for the deflationary environment is very much in question.

"This is a little bit trickier than going out to the long end of the curve, because we could see some sort of implosion in the Treasury market," says Abigail Doolittle, founder of Peak Theories Research in Albany, N.Y. "It's a matter of timing that very carefully."

Doolittle says investors can use longer-term bonds, including the 30-year, but not as hold-to-maturity vehicles. Trading bonds is common for institutional investors but is a little tougher road to navigate for less sophisticated retail investors, who are best off using an experienced advisor for help.

She is an even bigger advocate of cash, including foreign dollars such as Canadian and Australian denominations—countries that have raised rates and defended their currencies.

"Just because of the massive deficit, it's really going to put pressure on the dollar and Treasurys. When that happens you could see a spike higher in yield and a spike lower in prices," she says. "That's something the retail investor does not want to get caught in."

Indeed, today's deflation tremors might only be a precursor to tomorrow's inflation earthquake, as easy-money Federal Reserve policies and huge cash reserves make their mark.

"Investors need to be very cautious to try to protect themselves against systemic risk and dollar risk," says Doug Noland, manager of the Federated Prudent Bear Fund , which holds a balance of shorted stocks and benefits on the stock market falling. "It's time for investors to hunker down through this period without big losses. This is an incredibly uncertain environment."