NEW YORK: For all the concern about budget deficits and the rising supply of debt, government bonds are the place to be so far in 2010, with returns topping equities and commodities by the most since February.

Sovereign securities from the US to Australia gained 0.68% on average in January, including reinvested interest, according to the Bank of America Merrill Lynch indexes. That compares with a loss of 4.11% for the MSCI World Index of stocks and a decline of 3.89% in the Standard & Poor's GSCI Index of 24 raw materials.

Investors expected another losing year after bonds posted the worst returns in a decade in 2009 amid record debt sales to fund efforts to pull the global economy out of the recession. Instead, the securities were January's winners on growing concern that the recovery will slow after China clamped down on borrowing, the Obama administration proposed limiting the size of banks and Greece's finances roiled European markets.

"We're going through an air-pocket of risk aversion," said Jack McIntyre, a fund manager who oversees $21 billion of international debt at Brandywine Global Investment Management in Philadelphia. "Our core view is bonds still have value. The global economy's going to continue to grow, but there's so much excess capacity that we don't see inflation pressures building."

McIntyre's Legg Mason Brandywine Global Fixed Income Fund returned about 1.9% last month, better than 85% of its competitors, data compiled by Bloomberg show.

No Slowdown

Treasuries rallied on Jan. 29 even though the Commerce Department said the economy expanded 5.7% in the fourth quarter. The yield on the benchmark 3.375% note due November 2019 fell 5 basis points, or 0.05%age point, to 3.59%.

The yield was 3.60% today as of 11:24 a.m. in Tokyo.

While gross domestic product rose at the fastest pace in six years, the report's inflation gauge showed a 0.6% increase, less than the 1.3% median forecast of 37 economists surveyed by Bloomberg News. This week the Labor Department may say the unemployment rate held at 10% in January, according to the median forecast in a separate survey.

With jobless rolls stagnating and prices stable, traders are pricing in less than a 50% chance of a U.S. interest- rate increase before July, federal funds futures on the Chicago Board of Trade show. A month ago they saw 66% odds the central bank would lift its target for overnight loans between banks to at least 0.5% from the record low range of zero to 0.25%.

"The expectation was this was going to be a year of recovery," said Michael Atkin, who helps oversee $10 billion in fixed-income assets as head of sovereign research in Boston at Putnam Investments.

Tame Inflation

Tame inflation is allowing governments to borrow at cheaper rates. Yields fell as low as 2.29% last week from 2.43% at the end of 2009 as bond prices rose, according to the Bank of America Merrill Lynch Global Sovereign Broad Market Plus Index, which tracks $16.9 trillion of debt worldwide.

Yields stayed between 2.1% and 2.6% last year. The range for Treasury 10-year note yields was 2.14% and 4%, compared with the average yield of 5.48% over the previous 20 years.

Treasuries returned 1.56% in January after posting a 3.72% loss last year, the largest since at least 1977, Bank of America Merrill Lynch bond indexes show. German bunds gained 1.43%, the most since December 2008, while U.K. gilts rose 0.77% and Australia bonds climbed 1.44%.

China, Fed

Regulators in China, which is poised to overtake Japan as the world's second-largest economy, began restricting new loans after unprecedented credit growth of 9.59 trillion yuan ($1.4 trillion) in 2009 fanned concerns of a property bubble.

The risk is that the global economy won't weather such moves, especially with 10% unemployment in the U.S. and the Federal Reserve preparing to close four programs this quarter supporting money markets and bond dealers. It's also on schedule to stop buying mortgage-backed securities by the end of March.

That comes on top of President Barack Obama's proposal last month to reduce proprietary trading at banks that the White House defines as not for the benefit of customers, as well as restrictions on investing in hedge funds and private companies.

"There's a short-term dynamic and you have to ask yourself if that's going to turn into a long-term dynamic," Putnam's Atkin said, referring to the flight to bonds.

Bond Bears

Bond bears point out there's enough good news in the economy to avoid fixed-income securities. Last week's GDP report showed that consumer spending, which comprises about 70% of the economy, rose at a 2% pace, more than forecast.

"The economy is recovering, albeit very slowly," said James Sarni, senior managing partner at Payden & Rygel in Los Angeles, which manages $50 billion. "People are beginning to open their wallets and spend money. That, combined with the fact that we are going to see more supply means we're probably going to see a rising trend in Treasury yields."

Sarni forecasts 10-year Treasury yields will end 2010 in the 4.5% to 4.75% range. An investor who bought 10-year notes at the end of last week would lose about 5% if the high end of Sarni's forecast is reached, according to data compiled by Bloomberg.

Public Debt

U.S. public debt rose 58% to $7.17 trillion from the end of 2007 as the government spent $955 billion on stimulus programs and $700 billion on a rescue package for banks. The 2010 budget deficit is forecast at $1.35 trillion by the Congressional Budget Office, after reaching a record $1.4 trillion last year.

Morgan Stanley strategists James Caron and Lawrence Mutkin reiterated at the end of last week their recommendation that investors sell bonds. The firm, which is one of the 18 primary dealers of U.S. government securities that are obligated to bid at Treasury auctions, expects 10-year U.S. yields to rise to 4.5% by the end of the first quarter or early in the second.

While "risks have increased, fundamentally we do not believe the prospects for global recovery have changed," Caron and Mutkin wrote in a note to clients published Jan. 29. "We see this unwind in risk as an opportunity to add to our core views for higher rates and steeper curves."

Greece Crises

One of the risks the Morgan Stanley strategists cited was Greece. The nation's bonds lost about 5% in January on concern the government wasn't acting quickly enough to plug a deficit that was almost 13% of GDP last year, more than four times the European Union's limit.

The European Commission said Jan. 27 that Greece hasn't done enough to tame the shortfall. Two days later, EU Monetary Affairs Commissioner Joaquin Almunia said the country won't default and that policy makers have no "plan B" to help it.

Treasuries offer good value after 10-year yields reached 3.65% last week, as most investors and policy makers are not paying sufficient attention to the risks posed by sovereign credit in Europe, said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey.

"We are going through the same denial process that we did in 2008," when policy makers allowed Lehman Brothers Holdings Inc. to collapse, intensifying the financial crisis, said Cheah, who is buying Treasuries. "The tsunami of sovereign risk is approaching us."

Inflation Bonds

Rising consumer prices are becoming less of a concern, as measured by the difference in 10-year yields between government bonds and inflation-indexed securities.

The gap in yields, which represents traders' expected rate of inflation for the life of the securities, narrowed by 0.21%age point in Germany from its highs last month to stand at 1.8%age points. In the U.K., the spread declined 0.14%age point to 2.90, and it shrank by the same amount in Australia to 2.79%age points. The gap fell 0.12%age point to 2.34 in the U.S.

"The concerns on inflation and interest rates seem to be put to rest," said Robert Kowit, a fund manager at Federated Investors in Pittsburgh who helps manage $3 billion.

New York-based Verizon Communications Inc., coping with subscriber losses at its fixed-line phone business, said Jan. 26 it will cut about 13,000 jobs at the division this year. Finmeccanica SpA, Italy's biggest defense contractor, said Jan. 29 it will temporarily lay off 1,500 people in aeronautics, defense electronics and aerospace.

"People started the year with a negative bias on bonds and have been caught a bit off balance," said Gregor Macintosh, head of rates at Edinburgh-based Standard Life Investments, which has the equivalent of $196 billion under management.