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The financial events of last year did not leave the fixed-income markets without their own volatility and uncertainty. I know that many readers have begun to use ETFs for their income holdings, so let me take some time to address the state of these markets specifically. When the world’s central bankers reduced interest rates to historic lows during the early 2000s, investors in search of higher yields purchased risky assets, but they paid for it when the risk came due. Except for U.S. Treasury bonds, there were very few places to hide once the storm hit in 2008—even long-term municipal bonds declined. Today, many investors are sticking with government debt—local, state, and federal—but they may be repeating their mistake in assuming that these investments are low risk.

The two major threats to government bonds are supply and inflation. Every level of government has massive and unprecedented deficits. Pension liability at the state and local level, falling tax receipts, unrealistic spending programs, and huge stimulus efforts are some of the sources of deficit. The states with the highest taxes are also the states that have the highest government spending and, now, the largest deficits. The cost of correcting these imbalances will hit their already disadvantaged economies harder than others, through either heavy borrowing, spending cuts, taxation, or a combination of the three. Most of these bonds are unlikely to default, especially the debt of states such as California, which is required to pay schools and bondholders first. An increased supply of debt will push interest rates higher, but ironically, higher taxes will make municipal bonds even more attractive than they are today.

Unlike the states, the federal government can print money to pay its bills. Treasury bond supply will rapidly increase due to another bank bailout plan and a $0.8 trillion stimulus package—on top of a deficit that was already set to top $1 trillion in 2009 alone—but with the Federal Reserve expanding its balance sheet, the government has the only buyer it needs. Foreign and domestic investors will anticipate inflation, however, and eventually they will refuse to purchase bonds that pay 0 percent interest in the short run, or less than 3 percent for 30 years. At these levels, the bonds may perform well during the ongoing credit deflation, but in the long term, chances are that inflation won’t stay below 3 percent for the next 30 years.

In the short term, however, the opposite is happening. Long-term Treasuries outperformed in the past 12 months, with iShares Lehman 20+ Year Treasury (NYSEARCA:TLT) up 13.64 percent, even after a drop of 13.07 percent in January. The Fed said it may purchase long-term government bonds, so this drop could be reversed, but investors should remember how fast these bonds fell during a relatively mild sell-off.

Over the past three months, PowerShares Emerging Markets Sovereign Debt (NYSEARCA:PCY) has popped 36.39 percent. It was followed by long-term Treasuries and some corporate bonds. Emerging market currencies have been very volatile, and investors should expect big swings in both directions. In January, PCY was also the best performer, up 9.35 percent. Other funds leading the pack were short-term Treasuries, municipal bonds (iShares S&P National Municipal Bond, MUB), and mortgage-backed securities (iShares Lehman MBS Fixed-Rate Bond, MBB). Mortgage-backed securities also have done well in the past three months, thanks to the Federal Reserve’s entering this market.

In the next several months, the Federal Reserve and the federal government will pump trillions of dollars into credit markets. Yields will fall and the riskiest bonds will likely rally strongly. High-yield corporate bonds and junk bonds (iShares iBoxx High Yield Corporate, HYG) may be the most attractive areas, because the bonds will appreciate if credit floods the system, but they also offer downside protection if interest rates increase. Meanwhile, long-term Treasuries may be the least attractive, as they offer no protection from inflation. TIPS (NYSEARCA:TIP) may do well; investors should consider buying newly issued bonds, because deflation can lower the principal but these bonds cannot go below par value. Municipals are also likely to perform well, but with more volatility than conservative investors may want. For those living in a high-tax/high-debt state, munis may be a good way to protect against tax increases—but at the risk of rising inflation.

Finally, short-term investors should consider purchasing individual bonds to reduce volatility. Bond funds reprice at least daily in the case of mutual funds, and continuously for ETFs. Even a muni bond fund could drop 10 percent during a panic, but an investor holding the bonds can ignore the volatility and wait for maturity.

Fixed income isn’t what it used to be. Many aggressive traders have moved into the government fixed-income sector in search of short-term profits or downside protection. At the moment they are a better asset class than equities, real estate, or commodities, and for this reason they are richly priced and carry higher risk. Corporate bonds offer a better risk/reward ratio because of their higher rates, but they do carry bankruptcy risk.

Source: ETFs for a Challenging Fixed-Income Market