MONEY

Protect yourself from a Treasury market collapse

Treasury yields have been on a tear lately. Unfortunately for people with Treasury bonds already in their portfolio, that means that the prices of their holdings have dropped like a rock. If investors continue to gain confidence in the stock market, you can expect that trend to continue. You might have used Treasury bonds as a bomb shelter during the market panic. But now, your savior in 2008 could be turning against you.

If the Treasury market continues to weaken, a few notable investors might be saying, “I told you so.” Warren Buffett predicted a Treasury collapse in his annual letter to shareholders several months ago. “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s,” he wrote. “But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

What can you do about it? First off, if you panicked and put your money in Treasury bonds earlier this year, pare your bond holdings back to a percentage that’s right for your age. (If you don’t know what it should be, see Money’s asset allocation tool.) If you’re still too nervous to take risks on stocks, you can move the money to a short-term bond fund, such as the Vanguard Short-Term Bond index (VBISX), which is one of Money’s picks. A short-term bond fund might still have heavy investments in Treasuries (as the Vanguard fund does), but since the bonds’ maturity dates arrive soon, the funds’ share prices won’t drop as much as funds invested in long-term Treasury bonds.

Even if you stayed the course last year and didn’t binge on Treasury bonds, many of the mutual funds that you rely on for diversification could have. The fund doesn’t have to have “Treasury” in its name to be vulnerable. A fund that simply tracks a bond index, such as the Vanguard Total Bond Market index (VBMFX), will have a full 25% of its portfolio invested in Treasury bonds.

To see how much of your portfolio is exposed to Treasury bonds, use a website such as Morningstar.com that will break down how a fund is invested. Here’s an example using the Vanguard Total Bond Market Index fund referenced above. Under the “Sector Weightings” heading is what percentage of a fund’s assets are in U.S. Treasuries. You probably don’t want to cut Treasuries out altogether, but don’t have more of your bond portfolio in Treasuries than you’d have if you invested in a bond index fund. Right now, that sets the ceiling for Treasuries at about 25% of your bond portfolio.

Treasury bonds’ pullback might prove to be temporary, but if Buffett’s right, you’ll be glad you limited the damage.

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