Four Ways to Play the Bond Market Bubble

To hear the "bond bubbleistas" tell it, the bond market is poised to collapse the second interest rates start to rise.

But if you're thinking about dumping all of your bonds, you should think again.

Yes, rates will rise - but not as fast as many analysts are forecasting. What's more, even if rates do increase, the price risk is not as bad as you might think.

That's why the more appropriate strategy is to simply reorient your bond portfolio, rather than pull out all together.

Don't get me wrong. I'm not trying to make light of the global financial crisis or our current situation, but people have been calling for an "end" to bond markets, in one form or another, for quite a long time.

Failed ForecastsPIMCO cofounder and fund manager Bill Gross has actually done so twice, most recently dumping all government bonds in early 2011. He's since admitted he was wrong and piled back in. Granted, his business is bonds so he had to, but the point is moot.

PIMCO investors paid through the nose in lost performance, though. The PIMCO Total Return Fund was up just 3.2% as of August, trailing more than 70% of its peers and lagging the 5.6% return of its benchmark index, according to Bloomberg.

Meredith Whitney famously called for the $3 trillion muni-market Armageddon in November 2010. Her clock is about up and she's mentioning nothing about her prediction in recent appearances despite turning the bond markets upside down for months.

Even economist Nouriel Roubini has eaten crow when it comes to bonds. He called for the complete meltdown of everything we knew to be true in 2004, 2005, 2006, and 2007. And while he's since become a media darling, his predictive record is less than stunning. Journalist Charles Gasparino, who investigated Roubini's track record, noted that he couldn't find a "single investor who regularly uses his research."

My point is not that any of these incredibly smart people were wrong - everybody is wrong from time to time - just that investors risk a lot by not "risking" anything.

Let me explain.

No Substitute for StabilityFueled by banking blunders and the European banking crisis, U.S. Treasuries have not only risen this year, they've rocketed so high that in August the benchmark 10-year yield dropped below 2% for the first time since 1950 and traded at around 1.96% yesterday (Thursday).

That means investors who hung in there despite the risks and the hype have enjoyed a nice return from bond appreciation even as they continued to reap the benefits of the yield those bonds kicked off. Those who bailed out did so prematurely and got left behind.

So what's going to happen to the bond market when rates rise?

When rates do eventually start to rise, bonds will decline - but not at the pace many fear.

How do we know that? Because there is precedent.

Consider the period from 1993-94, for example. During that time, interest rates on 10-year Treasuries rose 50% from 5.3% to 8% in a mere 13 months. Yet the Barclays Capital Aggregate Bond Index fell just 3.5% over that period because income shielded the principal value.

Sure, individual bonds tumbled, but funds generally held a steadier, controlled hand on the tiller. Over longer time periods, this is a significant buffer.

People forget that interest payouts, while they can be small when rates are low, really do offer a cushion against falling prices - even if it's just a small one.

They also tend to forget that if fund managers hold bonds to maturity, the drop in bond prices is not actually offset because there is no realized "loss" to contend with. The reason is that bond prices move back to par as the bonds approach maturity. This is true whether you hold them individually or as part of an investment in an exchange-traded fund (ETF) or bond fund.


So, even though our country is functionally bankrupt, and the bond market is at frothy levels, I still believe investors would be foolish to dump bonds entirely. Limit your exposure and hedge your downside risk - but don't dump them.

Because for all their risks, bonds have been and will continue to be an important stabilizing force in your portfolio - bubble or not.

Four Ways to Beat the Bond BubbleThat said, there are four things you can do to limit your exposure to the bond market - and its downside risks - without pulling out entirely.

Keep durations short. Duration is the measure of a bond's sensitivity to interest rate changes. Basically, it works like this: For every year of duration, a fund or an individual bond will gain or lose value that's directly related to interest rate moves. A five-year duration, for example, will roughly equate to a 5% fall in face value for every 1% increase in interest rates. That's why I believe investors should keep duration under five years and preferably under three if they can. This will help minimize losses if rates rise, and it will give you much needed stability. You'll also have the opportunity to continually buy new bonds at higher rates.

Pick up Treasury Inflation Protected Securities, or TIPS. These specialized securities are linked to the consumer price index (CPI) so they're not going to move quickly as long as the government remains in denial with regard to inflation. However, they will move eventually and no amount of creative accounting will be able to hold the CPI down once the inflation we all know is here begins to move through the system in earnest.

If you're aggressive and want to profit from the looming shift in capital that will eventually accompany our profligate spending rather than simply defend against it, consider shorting long government bonds using an inverse fund like the Rydex Inverse Government Long Bond Strategy Fund (MUTF: RYJUX). It's down 26.82% year to date and that means mainstream investors are still looking the other way. Just as we are using short duration to our advantage as a defensive measure, this fund actually capitalizes on those who maintain a long duration. That means you can play offense.

[Editor's Note: There's one more idea about how to brace for bond market turmoil, but it's only available to Money Morning Private Briefingsubscribers. If you're already a subscriber you can read about it in today's briefing. If you're not, then you can sign up by clicking here.]