Yes, but prepare to average back in as soon as rates approach fair value, and consider moving out to the longer end of the curve.

We recommend maintaining neutral allocations to risky assets, but are placing a greater emphasis on diversification given we are at a more advanced stage of the economic and market cycle and risks are beginning to rise. Our overweight recommendations are largely to markets more exposed to deflationary risks. In fact, from a global perspective, we judge deflationary pressures as much stronger than any signs of inflation. As a result, we continue to recommend watching sovereign bond yields closely and preparing to re-allocate into longer-duration sovereigns as yields approach fair value.

For US Treasuries, that time may be approaching. We now regard fair value for the ten-year Treasury to be 3.5%, with 2.7% as the low end of our fair value range. While it may be tempting to wait until yields reach 3% before beginning to move back into Treasuries, yields might not reach that level this time around (at least before the cycle turns). The ten-year Treasury yield topped out at 3% in September and December of last year amid concerns that the Federal Reserve would tighten sooner. Prior to that, yields had not topped 3% since June 30, 2011, when the Fed ended the QE2 program.

As the economy gains steam—and there are nascent signs that this is beginning to happen—yields could certainly rise. And from a long-term perspective, Treasuries at current yields are priced to disappoint as they do not appropriately compensate investors for inflation. By our estimates, if the ten-year Treasury returned to fair value over the next decade, its inflation-adjusted annualized return would be -1%. However, if you take a shorter-term perspective, the risk/reward trade-off improves. Consider that US Treasuries already price in meaningful increases in yields over the next two to five years. For example, the one-year US Treasury yield is only 0.09%, yet the two-year forward one-year rate is 1.96%, meaning that the market expectation is for the one-year Treasury to yield 1.96% two years from now. And the five-year forward curve prices in even greater rate increases. Of course, forward expectations can and do change, but for those worried about policy rates increasing sooner or by more than expected, the short end of the curve is more vulnerable.

The difference between spot and forward rates at maturities of ten years and longer is small relative to the shorter end of the curve, suggesting that the risk of rising rates is lower at the longer end of the curve. If inflation remains muted in the near term, as we expect, such Treasuries would likely experience positive returns consistent with their yield to maturity. In mid-July, the ten-year Treasury spot yield was 2.58% compared to 3.18% two years forward.

Furthermore, many of the characteristics that historically made long-duration bonds attractive still exist today. They provide excellent diversification characteristics in periods of falling real rates, as evidenced by the negative correlations to equities in recent years; they are highly liquid, which allows for rebalancing during periods of market turmoil; and implementation is cheap and easy. Even acknowledging the potential for lower returns than in the past, their remaining firepower is evident in 30-year US Treasury bonds, which would produce a total return of roughly 24% if yields were to fall 100 bps in a year from June 30 levels. Of course an increase in yield of 100 bps would hurt, but not as much, with a one-year total return of roughly -13%. Even the ten-year would experience a one-year total return of 11% if rates were to fall 100 bps.

To read more on this advice and for our other portfolio advice, please read my quarterly publication, VantagePoint.

Celia Dallas is Cambridge Associates’ Chief Investment Strategist.