Four Ways to Play the Bond Market Bubble

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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 Forecasts

PIMCO 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 Stability

Fueled 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.

Measure of Resilience

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 Bubble

That said, there are four things you can do to limit your exposure to the bond market – and its downside risks – without pulling out entirely.

  1. 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.
  2. 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.
  3. 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.]

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Lawrence Calagna | September 30, 2011

    You conveniently seem to forget that you recommended TBT almost one year ago, and I don't have to tell you where that jewel of an investment stands today. Be truthful to your subscribers before you go bashing others.

  2. Simon P | September 30, 2011

    Regardless of whether bonds go up or down in the short term investors should always consider:
    – China want's to get rid of it's huge quantities of US dollar denominated paper
    – Bonds pay little interest, at present less than the inflation rate, so you're losing money
    – The biggest buyer of US bonds is the Fed, with newly printed money
    – When the bond matures it will always be paid out with devalued dollars
    AND
    – With both US and muni bonds, you are lending money to insolvent institutions

  3. ROB REGAN | September 30, 2011

    "our country is financially bankrupt". It is a shame that you smart guys believe this. Our wealth is our productivity, and our magic US dollar printing press can print to its hearts content so long as there is equivalent productivity. What's more, bond sales do NOT fund our government. We are not relying on the Chinese – they are relying on us. Remember, we buy their crap first – only then do they turn around and buy treasuries because they have to park those US dollars somewhere. The reason PIMCO was wrong is because he thinks there is such a thing as a Bond Vigilante. There is no such thing – that is the same economic myth as the need to pay down, or pay off our "debt". When the gov spends it does NOT need to pay it off. If you had a magic wallet with cash that popped up whenever you needed it – would you owe it back to your wallet? See Simon P's point #3. We complicat matters with the gold standard relics known as the Fed and Treasury – but if you can see past those you'll realize we don't actually need to sell bonds. We can simply choose to print and spend and we don't have to "issue debt" or even call it "debt" because it is not debt when you owe it to yourself. Fix this flaw in your thinking and your predictive powers go through the roof.

    • joseph | September 30, 2011

      yes the government CAN just print dollars infinitely the problem is that those dollars are worth less and less(as measured by the cost of food), and the whole point of investment is to try own things that INCREASE in worth

      no the usa wont technically go bankrupt because of that magic wallet, but for that doesnt change the fact that any institution withought that magic printing press in the same financial situation as the usa WOULD go bankrupt

      this means that the usa will have no choice other than to use that magic printing press in exactly the way you described, wich destroys the worth of the dollar, wich as i explained is important to investors

      food is the realest currency

    • Simon P | October 3, 2011

      The USA IS financially bankrupt. What American family can afford their $700,000 share of US government debt? Even Obama has admitted "America has no money, it's all gone"
      Regarding "equivalent productivity" do you really believe that workers are producing 3X as much as in 2007, because that's how much the money supply has multiplied thanks to QE 1 & 2?
      Bond sales DO fund the government. The argument over raising the debt limit centred on whether bond sales could continue. Without them, the Government would have (and nearly did) ground to a halt.
      If the US doesn't pay off it's debt (defaults) or inflates it's way out of debt with newly printed dollars, it will lose reserve currency status, and anything it wants to buy (eg oil) will have to paid for in another currency (even gold) which IT CAN"T PRINT.
      Remember, 70% of newly issued bonds are bought by the Fed, via QE 1,2,3 etc. When that stops, no-one will want US bonds except at high (junk bond) yields. The value of existing bonds issued with low yields will tank, until the yield is equivalent to the new ones. The Fed will not be able to hold down interest rates for ever.
      You need to join Dick (Deficits Don't Matter) Cheney in the looney bin.

  4. Gordan Finch | September 30, 2011

    Fuel prices are the IMF led EU imposed catalyst of inflation that has lead to the approach of economic collapse.

    Transport is the fundamental building block of any economy. 99.9% of all goods sold owned or used in homes, factories, shops etc (came on the back of a lorry). And this cost has escalated beyond the point of no returns for the treasury.

    If your argument is it came by Train, Boat, Canal, Horse, Plane or whatever. Then you are wrong, it was delivered to the boat plane train etc, including the food or grass seed that fed the horse. (It came by lorry.

    The damage done by VAT and Fuel Duty, is a TAX that has killed Incentive and as a result of fuel cost. The increased tax on fuel has become counterproductive for raising further tax revenue. It is clear that a 0% tax rate raises no revenue, also a 100% tax rate will also generate no revenue because there is no longer any incentive for a sensible taxpayer to earn any income, thus the revenue raised will be 100% of nothing.

    This is the prime reason Europe and other economies are stagnating, and the reason why this double dip will become a depression without intervention of authorities,

    1) Steps need to be taken urgently, (remove Fuel Duty and lower Vat).

    2) Incentives for small business start-ups with free premises capital allowances and interest free loans guaranteed by Government share ownership, with buyback option.

    3) Give transport of goods priority over everything and provide low cost. Quality safe stops for food, parking, and stopover, (sleeping.

    4) Create priority for SME manufacturing with tax free zones close to major road networks

    5) Ensure a low cost or free high speed fibre optic Internet access is given a priority to all businesses especially SMEs.

    6) Remove the Gold plated Civil Servant rules, ensure Government red tape rules are removed starting with the Planning department of all Authorities.

    7) Begin one of the largest road-building infrastructure projects ever undertaken and do this by Laws to stop protests.

    8) Build bus in the sky travel lifts over existing roads and motorways. This will free up the motorways etc for cars van trucks etc. Trams and trucks don’t mix. The cost to build a monorail or moving wire is less than a road.

    9) Allow the Euro to devalue or revalue as per Country fiscal conditions.

    10) Stop the Government and Corporate fraud, backhanding and corruption.

  5. Derek H | September 30, 2011

    I would've expected advice like dollar-cost average out of bonds (rather than dumping all at one time), buy dividend-yielding equities and preferreds, or use put-verticals and risk-reversals in the options market on the T-Note and Bond futures. But suggestion 1, buy short duration, puts you at odds with the supply of short duration bills the Fed is dumping, with little to no upside advantage. Reverse your argument on interest rate/face value, and tell us how much upside there is when the interest rate is a measly 25 basis points. The risk there is almost entirely to the downside, read: stay away. Suggestion 3, short long bonds, puts you at odds again with where the Fed is sopping up supply, driving prices higher. There's a good reason those inverse funds have gone down. One day they may turn, but there's no catalyst given for why it would be today. Suggestion 2, use TIPs, when you admit "the inflastion we know is here" essentially concedes that: Yes, there is a lot of creative government accounting that avoids recognizing it! Who needs more suggestions like these?

  6. MALDONADO29559 | October 1, 2011

    I have just one question if you will,

    So, if the bonds market goes south, wouldn't that mean that institutions will start taking money out there and start pumping more money into the stock market? Just a thought, otherwise where else would they be putting their money?

    Thanks,

    Carlos

  7. Craig Bradley | October 2, 2011

    Don't forget interest rates were around 10% in 1981 when Paul Volker began his term as the new FED chairman. He raised rates to a peak of 20%. There is no rule that interest rates could not go just as high or higher in future years, it just won't happen as long as everyone is deleveraging and selling assets for hard currency.
    Sooner or later the bad debt will be purged, inspite of the Federal government interference. Then and only then will the real economic recovery happen and when it does all those dollars floating about will push up inflation. If it were to go up fast and high, like in the 1970's, long bond holders would get killed. That's why you don't want longer durations, as Keith mentioned.

  8. BRET HOLMES | October 4, 2011

    Dear Mr. Calagna:

    Thanks for the note, and for the comment.

    However, I have to point out that your comment doesn’t portray the complete picture of the trade that you referenced.

    As you noted, Keith did recommend TBT a year ago. And, yes, that was not a winning trade.

    However – and this is very important – you neglect to also mention that Keith consistently advocates the disciplined use of “trailing stops” as part of all investing strategies. They are a key element of the trading services that he oversees, are repeatedly referenced in The Money Map Report, and have been written about extensively here in Money Morning. In fact, here in Money Morning he’s regularly written entire stories about safe-investing strategies, with trailing stops being a central element.

    The bottom line here is that, with these stops that he advocates, readers should have exited the position with a small manageable loss when the trade started to run against expectations – rather than hanging on only to watch it become a massive mistake.

    Let’s be honest here, too. There isn’t an investor in the world who posts a winning trade each time. And just because a particular stock, bond or fund doesn’t work out during one time period doesn’t mean it won’t prove to be a winner in a different time period, under a wholly different set of economic and financial circumstances.

    Lastly, having had the pleasure of working with Keith for four years now, I know him to be a forthright guy. He’s the first to admit when a trade didn’t work out. And I believe that’s one of the reasons that he has such a broad following, and is such a popular speaker at the many events he attends each year – not to mention with the thousands of Money Morning readers who see his columns and interview comments each week.

    Again, sir, I truly do appreciate the time readers take to respond to a story. And clearly you’re a regular reader – meaning you’re someone we value. But as a career journalist, I also think it’s important that all the parts of a story are told.

    I hope you continue to read us, sir. And I hope that we hear from you again.

    Very respectfully yours;

    William (Bill) Patalon III

    Executive Editor
    Money Morning and Private Briefing

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