How to Protect Yourself From the Collapse of Treasury Bonds

By now, you've probably taken note of the growing bubble in Treasury bonds.

The yield on the 10-year Treasury bond fell below 2% for the first time in 50 years in the wake of the U.S. credit rating downgrade.

That's irrational, and more importantly, dangerous.

A Treasury bond bubble is a unique creature. In fact, it's never been seen before, so determining its fate requires some careful thought.

But what's absolutely certain is that U.S. Treasuries are not a safe haven investment - far from it.

Treasury bonds carry five very dangerous risks - including negative yields, higher inflation, panic selling, an outright collapse, and default.

So let's take a closer look at those risks before determining the best way to profit.

First, real yields on Treasuries, after accounting for inflation, are now negative. Not only are nominal Treasury yields below the current inflation rate, but 10-year Treasury Inflation Protected Securities (TIPS) have traded on a yield of less than zero.

That is very unusual and economically distorting. Long-term bond yields in the zero-inflation 19th century never fell below 2.2%, which is to be expected. The guy who provides the money should get paid for doing so. However, any reversion to historical patterns would cause a major bond bear market. Ten-year Treasury yields would rise to the 5% to 6% range - even if inflation gets no faster - giving investors a 27% mark-to-market loss.

The consumer price index (CPI) inflation is up 3.6% from last year. And it's likely to rise much further as a result of the Federal Reserve's loose monetary policies.

If inflation were to rise to 10%, which is perfectly plausible, bond yields would have to rise to 12% to 13%, giving investors a 59% mark-to-market loss as well as eroding the value of their principal.

Yet there's an even greater threat than inflation, and that's the U.S. budget deficit. The United States is currently running an annual $600 billion balance of payments deficit. That deficit is being financed through the sale of Treasuries to foreign buyers.

Should foreign buyers cease buying, the dollar would have to fall to equalize the payments balance, perhaps by 20%. As a dollar investor, you might not mind this (though it would increase inflation). But foreign investors will hate it. The likely result would be the panicked selling of Treasuries, which would cause yields to rise sharply and prices to fall.

Finally, there's the risk of an outright default. Short-term, that's an infinitesimal risk - but a risk nonetheless.

After all, Treasuries used to be thought of as "risk free." Now, following the S&P downgrade, they are considered "low risk."

If the public repeatedly elects politicians who can't or won't take effective action to cut spending, particularly in the entitlements area, then debt eventually will spiral out of control and become impossible to repay.

You're probably free from this risk in five-year Treasuries, but not in 30-year Treasuries.

Theoretically, governments can't go bust in their own currency, since they can always print money. But that's nonsense. There comes a point at which you have to wheel the stuff around in barrows to buy groceries - as was the case in Germany in 1923. At that point, governments have to default - there's no alternative.

With such a broad collection of risks, Treasuries should be avoided like the plague. One or more of these five wealth-destroying events will almost certainly come to pass.

So here's how to protect yourself.

To profit from rises in Treasury bond yields, you might consider the Rydex Inverse Government Long Bond Strategy (MUTF: RYJCX), the price of which is inversely linked to T-bond prices (the fund shorts Treasury bond futures.).

Another alternative is the ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT), which rises by double the amount the 20-year T-bond future falls - but be careful with this one, it has to rebalance its portfolio each day, so if prices jump about, its value quickly erodes.

However, those won't protect you against currency losses or inflation. To avoid currency losses, buy a foreign currency, perhaps Australian dollars, Canadian dollars or Swiss francs. To avoid inflation, go for gold.

Nothing can protect you completely against the bursting of the Treasury bond bubble - it will have an adverse effect on the economy as a whole, affecting all your investments and possibly your business or employment.

Still, you can mitigate the problem with the right investments.

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