<p>Widows and Orphans Beware: Treasurys Might Not Be So Safe</p><p>It's been four decades since Treasury bonds were this popular. Widows and orphans, watch out. Battered by a bruising stock-market decline, many investors have sought refuge in government bonds. That's driven the yield on the benchmark 10-year Treasury note below 4%, a level last seen in the early 1960s. My fear: These folks may be swapping one losing proposition for another.</p><p>Remember, bond prices and interest rate move in opposite directions. That has lately meant a bonanza for bond investors. Prices have climbed smartly as the yield on 10-year Treasurys has fallen to 3.86% Tuesday from 6.44% at year-end 1999. But what if rates rise instead? Forecasting the bond market's direction is a mug's game. Still, this much is clear: Treasury bonds are now a whole lot riskier, for three reasons.</p><p>First, from current levels, interest rates have a lot more room to rise than to fall. After all, there is a floor on interest rates, because yields are unlikely to drop below zero. But there is no ceiling. Indeed, in 1981, 10-year Treasurys yielded almost 16%.</p><p>Second, as yields come down, bonds become much more volatile. Why? Suppose interest rates climb from here. Because today's yields are so low, there is less of a cushion to soften the blow from rising rates.</p><p>Third, the spread between the yield on Treasurys and those on corporate bonds is unusually wide. Even if overall interest rates don't climb, there is a chance that the spread will narrow, hurting Treasury investors.</p><p>Of course, as I often note, markets aren't stupid. There are some good reasons for these paltry yields. Stocks are in the third year of a brutal bear market. Corporate bonds seem iffy, thanks to all the accounting scandals. Meanwhile, inflation is subdued and the economic recovery is still tentative. Against that backdrop, it is little wonder Treasurys are so popular.</p><p>But while government bonds may seem like a safe haven right now, they are likely to be a lousy long-run investment. Ian MacKinnon, head of fixed-income investing at Vanguard Group in Malvern, Pa., notes that bond investors typically look for a return above inflation of three or four percentage points a year. But to get that return from 10- year Treasurys, you would need inflation close to zero.</p><p>"The market is saying inflation is going to be very well behaved for the next 10 years," Mr. MacKinnon says. "That is a level of optimism that I find difficult to share."</p><p>Inflation ran at 1.5% over the year through July. That figure is likely to climb, as a reviving economy drives consumer prices higher. Indeed, low inflation isn't exactly the norm. Since the Second World War, there have been just six calendar years when inflation was below 1% -- and the last time was 1961.</p><p>Curiously, while buyers of 10-year Treasury notes are banking on low inflation, investors in another type of government bond are making the opposite bet. Inflation-indexed Treasury bonds, which provide a guaranteed yield above inflation, have rallied strongly this year. That suggests investors believe there is higher inflation to come.</p><p>If inflation does pick up, rates will likely rise. That would be bad news for investors in 10-year Treasury notes, as the accompanying chart makes clear. If rates climbed one percentage point over the next year, these folks would lose 4.1%, even after taking into account the interest earned during that 12-month stretch. If rates rose two points, they would lose 12.1%.</p><p>What to do? If you are worried about renewed inflation, you could join the rush into inflation-indexed Treasurys. But I worry that the bonds have already had their run.</p><p>"They're no longer the gift that they once were," agrees Eric Seff, a financial planner in Mamaroneck, N.Y. "Where should you go? You might look at a short-term corporate bond fund or a money-market fund."</p><p>With corporate bonds yielding so much more than Treasurys, buyers of corporates not only collect more income, but that higher yield will also provide a buffer should rates rise. Mr. Seff recommends Vanguard Short-Term Corporate Fund. He also likes TIAA- CREF Short-Term Bond Fund, though he notes that the fund owns both corporate and government bonds.</p><p>Alternatively, you might opt for an investment whose value won't be hurt by rising interest rates. You could plunk for a certificate of deposit or invest in a stable-value fund. Stable-value funds, which are part of many 401(k) plans, aim to avoid fluctuations in principal while delivering decent yields.</p><p>You might also look into tax-deferred fixed annuities. But if you go that route, be careful not to get sucked in by high teaser rates and pay careful attention to the surrender charges imposed. Minneapolis financial planner Ross Levin has been putting older clients in the fixed annuity offered by New York's TIAA-CREF. The annuity currently pays 4.7% and has no surrender charge.</p><p>"I never in my life imagined that I would be regularly recommending fixed annuities," Mr. Levin concedes. "But they make sense right now, because you get a great guaranteed yield with no chance you'll lose money if interest rates rise."</p>