Is the Bond Bubble About To Burst?

2013 Bond Market Forecast

When the global economic crisis hit in 2008, investors everywhere abandoned the stock market and piled into bonds.

Treasury sales boomed, thanks to their perceived relative safety and stability. Since early 2009, investors have poured more than $500 billion into U.S. bonds.

There was just one problem...

All that demand pushed bond prices way up, to what analysts feel are unsustainable levels, and sunk yields to multi-decade lows. (Short-term bonds pay virtually nothing right now. The Vanguard Prime Money Market Fund (VMMXX) today yields just 0.04%!)

Indeed, the combination of large supply, enormous demand, and unsustainably inflated bond prices has formed nothing less than a bubble in the U.S. bond market. Now there's only one way bond prices can go - down.

It doesn't take a financial whiz to figure this out.

In fact, this simple chart below tells you everything you need to know about the Treasury Bond market.

When the U.S. economy is in balance, the return on long-term Treasury bonds is around 2% to 3% above the expected rate of long-term inflation. If inflation gets a grip, it's likely to rise to the 3% to 4% range. That means when - not if - the Fed is forced to increase interest rates on newly issued government debt, the yield on long-term Treasury bonds could easily climb to 6%. Investors will flock to these higher-paying bonds... and ditch their low-yield Treasuries en masse.

Existing bondholders could get crushed.

So while there is little doubt that the Fed's articulated and executed policies have resulted in a bond-bubble with both short and long-term consequences for investors and the economy... The big question investors are asking is... when and how will the implosion take place?

At some point the bond-bubble will burst. But there is no certainty on when that will happen or what ultimately will cause rates to rise.

What investors need to understand is that while yields and bond prices in 2013 could remain flat relative to closing third quarter 2012 measures, yields are unlikely to fall further and prices are unlikely to rally in

2013, with the possible exception of short-term U.S. treasuries.

However, there is the possibility of what I'm calling a "skyfall."

For fixed-income investors this means there is a chance the bond bubble may finally burst in 2013.

2013 Bond Market Forecast: From Flat to Skyfall?

Skyfall is the title of the latest James Bond film, which viewers discover is also the name of Bond's childhood home in Scotland, before it is blown apart in the movie's climactic finish.

Now, because interest rates across the board have fallen to historically low levels, the great bond rally could suffer a similar climax.

Here's where we stand now, why the bond rally is likely over, what could happen in 2013, and what early warning signals to watch for to get out of the way of this skyfall.

Editor's Note: One chart shows an even more dangerous economic crisis brewing right now. See the "eerie" chart here.

As yield-hungry investors have plowed more and more money into bond mutual funds, bond ETFs, and, for institutions, individual bonds, issuers from sovereigns to junk dealers have rushed to the market to soak up the trillions of dollars searching for yield.

That circuitous path has kept money flowing into bonds in search of falling yields as issuers take advantage of low rates artificially manipulated by the Fed's actions.

All dollar-denominated bonds issued in the United States (and many issues globally) are priced off the U.S. Treasury yield curve.

That's the scale of interest rates that starts with the federal funds rate (even though the Fed doesn't issue fed funds) and displays the interest rates payable on Treasury bills, notes and bonds, up to and including the most actively watched, traded and talked about 10-year T-bond, all the way to the 30-year T-bond.

Treasury issues are considered "risk-free" because they are backed by the full faith and credit of the U.S. to pay all interest and principal on its debts.

All other bonds yield more (pay more interest) than equivalent-maturity Treasury issues to reflect the difference in "quality" between a Treasury issue and a municipal, corporate, or other bond issue.

The difference between what a Treasury's yield is for a particular maturity bill, note or bond and what the yield is on another issue is called the "spread."

The spread refers to the additional yield (the difference in the interest rate) issuers have to pay to attract investors who otherwise might opt for the safety of Treasuries.

As interest rates have been kept artificially low, investors looking for additional yield above exceptionally low-yielding Treasuries have been increasingly willing to accept smaller and smaller "spreads" when they buy bonds that aren't risk-free.

Issuers recognize investor demand for yield and know investors will still buy their bonds even as they offer less and less interest, because whatever yield advantage investors can get, they will gladly take.

As a result, the spread over Treasuries has come down for all issuers from top-rated investment grade issuers to leverage bond and junk issuers.

In other words, investors are not being adequately compensated for the increasing risk they are taking with issuers, who range from investment-grade corporations to special-purpose vehicles issuing junk bonds for leveraged and speculative endeavors.

The Fed's recent announcement that they will buy $40 billion per month of top-rated agency paper (mostly mortgage-backed-securities), only takes even more U.S. government-backed paper out of the market, leaving investors clamoring even more for whatever investment-grade ("IG") bonds they can get. That's a further boon to bond issuers.

In fact, in just the third quarter of 2012 (the latest quarter for which data is available) IG issuance, excluding sovereign, supranational, split-rated and preferred-stock issues, exceeded $215 billion -- a near record.

But that's IG. What's more telling, and evidence of how much investors are reaching for yield further out on the risk spectrum, is what third-quarter issuance was in the leverage and high-yield (junk) markets.

Leverage loans are loans and bond issues backing loans to corporations, companies and other issuers that already have high leverage on the debt side of their capital structure. High yield, also known as junk bonds, are debt issues offered by the most speculative issuers seeking debt financing.

Leverage bond issuance totaled $114 billion in Q3, a record, which included a constituent record $20 billion issued in August, historically the year's slowest month.

At the current pace, with $317 billion already issued year to date, leverage loans are on track to reach $423 billion, or exceed $508 billion if September's $63.5 billion pace continues.

And while the leverage loan market has been flush, the high-yield market has been doing its own hot issuance thing.

Bond-clearing yields fell in the third quarter to all-time lows, even though spreads are still above record lows. High-yield issuance in the third quarter was $91.9 billion, the second highest on record. The highest quarter ever was this year's first quarter at $99.9 billion. Full-year 2012 junk issuance is closing in on the record $287 billion issued in 2010, and likely to exceed it.

Combined leverage and HY issuance in all of 2012 is expected to exceed $748 billion, topping the former record of $679 billion reached in 2007.

We Know What Happened Next....

With rates so low and investor appetites still high, we're seeing more and more "covenant-lite" deals, the ones that afford more protections to issuers than to investors.

Investors need to look through the froth in the bond market and realize that a lot of bonds are issued with call features and are in such demand that they are trading at premiums to par value, or what will be returned at maturity.

With prices so high and yields so low, all relative to the risk of holding bonds in a bubble-like market, investors need to have an exceptionally strong stomach to wade into the bond market now or in 2013.

Investors also need to beware of false rallies.

The risk-off trade, where equity investors flee to the safety of Treasuries, could make Treasury prices rise and bonds look like a safe haven. They could be, for a while.

Then there's the outside threat of inflation that would cause rates to rise and bond prices to plummet. Or the move to the risk-on trade, which would signal that equity investments are preferred to the low-yielding safety of bonds, which could decimate bond prices.

Or there's the chance that the economy double-dips in 2013, putting pressure on leverage loan and high-yield issuers to make interest payments at the same time that investors flee their bonds and raise capital structure costs for them.

I'll be watching the derivatives markets, namely the credit default swap indexes like CDX-IG-19 to see if default insurance costs start rising, by how much, how fast, and on which indexes.

Video Investigation: Nearly 5 years ago derivative trading collapsed the entire world economy. Yet today we have 10-20 times the amount of phony derivatives floating around than the entire size of our global GDP. What does this mean for the economy today? Find out here.

In the meantime, here's how to protect your portfolio... and turn the bursting of the bond bubble in your favor.

As Bond Prices Fall, Opportunity Knocks...

There's a brilliantly simple way to profit when interest rates rise and long-term Treasury bond prices fall.

All you have to do is buy ProShares UltraShort 20+ Year Treasury (NYSE:TBT). It's the perfect tool for aggressive investors seeking leveraged short exposure to the U.S. Treasury market.

Here's how it works:

TBT is designed to go up by 2% for every 1% decline in the index it tracks (the Barclay 20+ Year Treasury Index). Fund managers do this by selling futures each day to an amount of twice the value of the fund and rebalancing the fund's position at the close of each day.

With net assets of nearly $3 billion, TBT is the single largest leveraged inverse fund. It is large enough to give you liquidity getting in, yet small enough that its hedging activities will not distort the long-term Treasury futures market, which is many times larger.

Like any investment, UltraShort shares come with inherent risk. The rebalancing process produces a tracking error, by which the return on the fund diverges from its theoretical expectation of twice the underlying index's decline. If the underlying index is volatile, this tracking error can be substantial.

But don't worry. That's not the case with TBT.

The fund's underlying index of Treasury bond prices is both highly liquid (and thus easy to hedge in size) and relatively stable.

Hence the tracking error is considerably lower; it appears to have been less than 10%, though that is still enough variance to caution its holders. So while you won't necessarily get a full "twofer," you will get a substantially heightened gain.

The fund, of course, is meant to reflect the daily ups and downs of the market, so you should not consider it a long-term investment. The longer you hold shares, the bigger the risk that they will veer away from the benchmark. And that's okay.

Based on the fundamentals, we don't think it'll take very long to make money with TBT. In fact, you could see significant gains in a matter of weeks.

The U.S. economy is a mess. The exorbitant deficit and imminent inflation will send interest rates higher (much higher, perhaps), and the long-term bond market will turn upside-down.

And you'll be able to make a lot of money when it does.

Action to Take: Buy ProShares UltraShort 20+ Year Treasury (NYSE:TBT) at market. And use a 25% trailing stop to protect your principal and your profits.