What's Next for Government Bonds?

Should investors cut their losses or wait out the storm?

Closeup view of 100 dollar us savings bonds
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Mutual funds that invest in U.S. Treasurys have been under siege on all fronts over the past several months. As investors in these funds take a beating, they face a classic dilemma: sell before things get worse or wait out the storm?

As of Friday, funds that specialize in long-term U.S. government debt were down by an average of 12.2 percent in 2013, according to Morningstar. That makes them the worst-performing bond category so far this year.

[See: 10 Target-Date Funds Producing High-Grade Nest Eggs.]

The poor performance of Treasury funds has a number of root causes. Chief among them is the concern that the Federal Reserve will begin to taper its market-boosting bond-buying program in the coming months. That, in turn, would cause interest rates to rise and bond prices to fall. Long-term Treasurys funds have been hit especially hard because bonds with longer durations are particularly sensitive to spikes in interest rates.

A second factor is the low yields Treasurys are offering. As of Friday, 10-year Treasurys were yielding just 2.82 percent. Unable to get respectable yields from Treasurys, many investors have turned to other products, including junk bonds.

[Read: Sweet-Smelling Junk: High-Yield Funds Have Had a Strong Showing.]

Finally, as the stock market has rebounded and reached new highs, investors have been less likely to feel a need for the type of safety net Treasurys provide. Indeed, such securities tend to be most appealing during times of market turmoil when investors feel uneasy about other kinds of investments. By contrast, a healthy stock market tends to draw attention away from the sector.

Given this outlook, a number of investors have cut back considerably on their Treasurys holdings in 2013. But what about investors who still hold significant positions?

Analysts caution that the poor performance is not a reason for retail investors to completely do away with their Treasury holdings. Treasurys are an important part of most long-term portfolios, and they are particularly useful for conservative investors, including those at or nearing retirement.

"You need to have an asset-allocation plan," says Adam Patti, CEO of the New York-based company IndexIQ. "And fixed income and Treasurys are always a part of that." Nonetheless, he cautions that fund investors who are overweight in Treasurys consider reducing their holdings. "Treasurys have run up so far for so long [that] there's a lot of downside left," he says. "It's still certainly a good idea now to start carving off part of your position."

However, Chris Bouffard, chief investment officer for the Mutual Fund Store, suggests that investors looking to cut their losses may have missed their chance and should instead think about waiting for a rebound. "It almost feels like at this point it's worth waiting for a bit of a bounce-back," he says.

[Read: Target-Date Funds Sliced By Bond Buzzsaw.]

The looming question is how aggressive the Federal Reserve will be with tapering. In theory, rising rates will cause Treasurys funds to lose even more money. However, the effect may be muted somewhat by the fact that rising interest rates will not come as a surprise to investors.

In other words, these funds have already declined in anticipation of rising rates to the point where an actual spike is unlikely to have a major impact, since it would merely confirm what investors already believed. "It certainly feels like a lot of [the downside from rising rates] in the short term has been priced in," Bouffard says.