Talk of a bond market crash has been building for months, and not just among obscure financial bloggers.
Articles sounding the alarm about a bond market crash have appeared time and again in many mainstream publications.
Recent headlines like "Danger Lurks Inside the Bond Boom" (The Wall Street Journal), "How Banks Could Get Blown Away by Bond Bubble" (Fortune), and "Beware the Bond Bubble in 2013" (CNNMoney) have raised concern among investors.
Here's the problem: Interest rates are at historic lows. That makes bond prices relatively high.
There's pretty much nowhere left for rates to go but up. That might be good for buyers of bonds in the future, but terrible for those who hold bonds stuck at low rates.
Bond funds, a favorite of conservative investors, would get hit particularly hard as their existing holdings would rapidly start to lose value.
How We Could Get a Bond Market Crash
Some believe the Federal Reserve will take its foot off the gas of quantitative easing this year, and QE has helped keep interest rates so low.
Minutes from the December Federal Open Market Committee (FOMC) meeting showed several members "thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet."
The end of QE would not only let interest rates on U.S. Treasuries drift higher, but those on all types of bonds.
Another catalyst that could lead to rising interest rates is the so-called Great Rotation.
That term, coined by Bank of America Merrill Lynch in a report released last fall titled "The Bond Era Ends," predicted that investors in search of higher returns will start to move money en masse out of bonds and into stocks in 2013.
"Equities will become more attractive because they are geared to growth and offer returns that investors simply cannot get from their bond portfolios," John Bilton, European investment strategist at BofA Merrill Lynch, told the Financial Times.
As a result, some have predicted the value of bonds could drop as much as 50%.
Shah Gilani on a Bond Market Crash
A bond market crash of that magnitude would have devastating consequences, Money Morning Capital Wave Strategist Shah Gilani said.
"It would be beyond severe. It would be a traumatic hit to the economy, it would be a traumatic hit to investors, and it would be something that would take quite some time to recover from," he said.
Yet Gilani doesn't share the fear of a bond bubble that other Wall Street mavens have. While he acknowledges rates must rise, he said that a sudden, calamitous bond market crash is not in the cards.
"I don't foresee an abrupt turnaround in the bond market," he said. "Bonds will sell off eventually, yields will rise over time, but it's not going to be on the order of magnitude of a matter of days, weeks, or even months, or even a couple of quarters. It's going to take some time for yields to move substantially higher."
But at the same time, that doesn't mean investors can afford to ignore what's happening in the bond market.
To find out how the changes in the bond market will affect your investments and what you should watch out for, watch the accompanying video.
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