By Deborah Levine

NEW YORK (Dow Jones) -- A decade of falling prices is perfectly plausible to at least one very successful investor, so he's sticking with long-term Treasury bonds.

Lacy Hunt, an economist and fund manager at Hoisington Investment Management in Austin, Texas, is convinced that once an economy goes from a period from extreme over-indebtedness to falling prices, as the U.S. has now, it ushers in a decisive shift in markets.

And in the U.S. case, bond bulls say, the high levels of debt held by government, businesses and consumers will spell the nation's undoing.

"Once we start a debt deflationary event, historically they tend to be very pernicious," said Hunt, who helps oversee the Wasatch-Hoisington U.S. Treasury Fund (WHOSX), which returned almost 38% last year. The fund has 10-year annualized gains of 7.56%, making it the best performing long-government bond fund over that period, according to Morningstar.

"There are no quick fixes here, so we're in long Treasurys," said Hunt, whose fund manages about $4.5 billion in assets.

That strategy goes along with the expectation of some economists that falling housing prices will continue pressuring other parts of the economy. If a true deflation trend takes hold, the value of bonds increases because they have fixed coupon payments.

Indeed, deflation is anything but a threat to bond investors. Their cardinal rule is that one of the biggest risks of holding fixed-income debt is that inflation will erode their value.

Yields on 30-year bonds (UST30Y), currently at 3.55%, could fall to 2%, but it will likely take more than a decade, in Hunt's view. As yields fall, prices move in the opposite direction and strengthen, which would benefit bond holders like Hunt.

As much as the government is trying to steady financial markets and encourage lending, stimulus in the system isn't flowing through to consumers, said William Bellamy, who manages about $1 billion as director of fixed income at Thompson Siegel & Walmsley.

And with the job market as weak as it is, wages -- a key component of business costs -- are likely to remain subdued, a trend that allows companies to lower their prices.

"I'm in the deflation camp because it could take a while," said Bellamy, co-manager of the TS&W Fixed Income fund (TSWFX). "The only way for prices to go is down."

Flipping to inflation

Still, there are plenty of strategists and investors who expect deflation over the next several months, but not long enough to merit going whole hog into Treasurys.

"It's entirely likely we'll have some sort of mild deflationary period of the immediate coming quarter," said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union.

Personal consumption has dropped off, and is likely to remain that way or decelerate further, he said. That will set up a domino effect, because "there isn't any pricing power, so businesses will want to conserve market share and cut prices to work down excess inventories."

Certain costs, including rental housing and health care, have held up, and the government's stimulus plan is likely to spur economic growth at some point, even if not this year, Sullivan said.

"The market is expecting we'll be back to inflationary concerns in the coming years," he said.

One way for bond investors to protect themselves against rising inflation is to buy Treasury Inflation Protected Securities, which explicitly pay holders the government's rate of inflation in addition to a coupon.

TIPS, however, have sold off dramatically in recent months as some investors dumped them in favor of more liquid, regular Treasurys. That's shrunk the gap in yields between TIPS and regular Treasurys of the same maturities, used as an indicator of investors' inflation expectations.

Ten-year TIPS currently yield about 1.11% percentage point less than regular 10-year notes (UST10Y), meaning the price is relatively cheap for someone who expects inflation to top that over that time horizon.

Still, those low expectations and signs of deflation this year are unlikely to convince many that Treasurys are a good investment right now for the long term.

Riskier assets

If the economy is even weaker than currently expected, deflation may continue, said Michael Pond, a Treasury strategist at Barclays Capital. Still, the slowing growth would be the main catalyst for investors to shift to Treasurys from riskier assets, including equities and other types of bonds.

"A weakening economy, rather than deflation fears, would be the primary driver of other asset classes," he said.

Moreover, steps by the Federal Reserve and the government to stabilize the financial system have flooded the markets with liquidity, which tends to be inflationary.

"It may be difficult to remove the foot from the accelerator when they should," Pond said. "Officials are much more concerned about the downside risks to growth," so they may leave the stimulus in place a little longer just to be sure a recovery has taken hold. "The risk of the Fed and fiscal policy creating inflation down the road has increased, so the market should price in that risk."

Investors more concerned about inflation are likely to get out of Treasurys all-together, probably in favor of corporate bonds, Bellamy said.

"You'd want to get on the credit side of things and into the high-yield sector to have some cushion from inflation," he said.

Speculative-grade debt, also known as junk bonds, currently yields about 14 percentage points more than Treasurys, according to Standard & Poor's.

"In the near-term, the greater risk is deflation and the Fed is reacting to that," Pond said. "Longer term, more than several months out, the market should be pricing significant risks of inflation."