When the stock market swoons, investors typically head to the security of quality, long-term bonds, which tend to outperform stocks during recessions. Since the stock market's recent peak in October 2007, bonds have trounced stocks. Stocks are now in a bear market, defined as a drop of at least 20 percent from the recent high.

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When the stock market swoons, investors typically head to the security of quality, long-term bonds, which tend to outperform stocks during recessions. Since the stock market’s recent peak in October 2007, bonds have trounced stocks. Stocks are now in a bear market, defined as a drop of at least 20 percent from the recent high.

Treasurys have been a favorite safe haven since the credit crunch began in the summer of 2007, but the recent government bailout of mortgage giants Fannie Mae and Freddie Mac is funneling money into their bonds as well. Before the bailout, the bonds had only the implicit backing of the government. What’s more, investors had been steering clear of mortgage-backed securities due to the credit and housing crisis.

“In downturns, the market greatly values confidence of repayment,” says Frank James, founder of James Investment Research, which manages about $2.1 billion in stocks and bonds. “Return of capital, not return on capital, rules. Thus, those bonds thought to be of the highest quality do best.” Just after the takeover of Fannie Mae and Freddie Mac, James says prices on their mortgage-backed bonds gained more than 2 percent compared with a 0.18 percent gain for long-term Treasurys. Yields on 30-year Treasurys tumbled to 4.2 percent as of Tuesday, from 4.36 percent a week earlier.

Bond prices rise when interest rates fall, which tends to happen in recessions, James says. “People have disagreed with our view on interest rates,” says James, who expects the 10-year Treasury yield to fall to 3 percent within a year from 3.6 percent now. When rates fall, long-term bonds post the biggest gains. A drop in interest rates of 0.5 percent would produce a 13 percent gain for long-term Treasurys, he says.

Of course, if interest rates were to rise, prices of existing bonds would fall. The actions by the government to take over Fannie and Freddie could push the Federal Reserve to raise rates early in 2009, predicts Smith Breeden Associates in a report.