2007's Big Surprise

When the stock market has a blockbuster year, no one's particularly surprised. But even though stocks have put in a reasonably good performance after a topsy-turvy second half of the year, a much more conservative investment has done a lot better than many expected, giving broader-market indexes a run for their money.

Mutual funds that invest in Treasury securities have put in an unexpectedly good performance in 2007, especially at the shorter end of the maturity spectrum. Intermediate-term Treasury funds have done particularly well, in some cases even outpacing the S&P 500's return. Inflation-protected securities funds have done even better. And even shorter-maturity Treasury funds have performed extremely well.

A perfect storm
Treasury bonds have benefited from an unusual confluence of favorable circumstances. When the stock market plummeted in August, the selling panic pushed investors toward the safety of short-term Treasuries. Yields on the shortest-term Treasury bills quickly dropped a full 2%. And while intermediate-term Treasury yields fell more slowly, they, too, have fallen from a high around 5.2% in June to a low of 3.2% last month.

Meanwhile, the Federal Reserve began lowering short-term interest rates in October, adding more fuel to the fire under bond prices. As yields have fallen, the prices of Treasuries that bond mutual funds own have risen.

While these factors would tend to support bonds generally, gains have focused particularly on Treasury securities. The credit crunch has investors worried about the stability of the overall economy, so even investment-grade corporate bonds haven't seen the same gains that Treasuries have. Bond insurers Ambac Financial (NYSE:ABK) and MBIA (NYSE:MBI) are seeing their own bonds trade at junk levels, despite currently carrying a strong AA rating. Meanwhile, mortgage-lending problems have forced Washington Mutual (NYSE:WM) to cut its dividend, and led Countrywide Financial (NYSE:CFC) to seek a cash infusion from Bank of America (NYSE:BAC). These and other concerns have widened spreads between Treasuries and corporate bonds, which in turn has limited the participation of corporates in the bond-market rally.

Is it too late?
Chasing performance is always dangerous, and bonds are no exception. Unfortunately, the outstanding total returns Treasuries have enjoyed this year aren't sustainable. Although Treasury prices will rise if rates continue to fall, lower yields will limit the amount of income investors receive from their bonds. And once those yields hit rock bottom, returns are likely to languish. While bond funds also performed well during the bear market in stocks from 2000 to 2002, several years of low single-digit returns followed as rates crept back up.

Strong Treasury returns highlight the need to keep a diversified portfolio. Even when some of your investments start looking shaky, having exposure to many different asset classes helps you reap the benefits of a pleasant surprise like the one the Treasury bond market gave investors this year.

Learn more about:

• A high-performing fund you've never heard of.
• Where to find the next great mutual fund.
• How one-stop shopping makes big fund families attractive.

Also, visit our Bond Center to learn the basics.