Forget Stocks, What Happens When The Bond Bubble Bursts?

As I've stated in countless article before, the Fed is good at nothing but blowing bubbles. And while most commentators have focused predominately on the bubble occurring in stocks (if you compare where the S&P500 is relative to economic data we are DEFINITELY in a bubble), a larger, more frightening bubble is currently brewing in bonds.

Since the 2008 Crash, investors worldwide have generally shunned equities in favor of the perceived safety of the bond market. Nowhere is this more apparent that in the retail investor market, where investors have pulled money from stock based mutual funds for 23 weeks in a row, while they're on pace to pile some $300 billion into bond funds this year (on the heels of a record $350 billion in bond fund inflows from last year).

This trend in the retail investor market is largely based on fear of stocks (two bubble and subsequent Crashes in ten years will do that) and demographics (the aging boomer population, now punished by a Federal Reserve hell-bent on keeping interest rates at zero, is ravenous for income to help them move into their delayed retirement).

On the surface, this sounds pretty good. After all, stocks haven't returned anything in ten years. In fact, adjusted for inflation, they've LOST money over that time. Plus bonds DO offer the appeal of definite income compared to stocks ,which often don't pay ANY dividend or can experience large dividend cuts due to management screw ups or phony accounting coming home to roost (see financials from 2007-2009).

However, the numbers don't lie, we are most assuredly in a bond bubble. According to data compiled by Bloomberg and the Washington-based Investment Company Institute, investors have put almost as much money into bond funds in the two years ended June 2010 ($480 billion) as they did in equity mutual funds at the height of the Tech bubble from 1999-2000 ($496 billion).

And the insanity is literally across the board.

Treasuries are trading at levels not seen since the depth of the 2008 Crisis. We just had a TIPS auction close at a negative yield for the first time in history, meaning investors are willing to LOSE money just to park it with bonds that supposedly adjust for inflation (TIPS adjust based on the CPI which is nowhere near the REAL rate of inflation… see tomorrow's essay for more on this), and US corporations have ALREADY issued $217 billion in junk bonds this year, even HIGHER than last year's RECORD.

In plain terms, we've got a bond bubble of epic proportions on our hands. And if you think a stock market crash is something to behold, wait until the bond bubble bursts.

Remember, we've been in a bond bull market for well over 30 years. And while stocks have experienced at least three Crashes during that time (1987, 2000, and 2008), bonds have generally done nothing but go up over that period.

Because of this, there is an entire generation of professional traders/ analysts/ fund managers who have never invested during a bear market in bonds. These folks have made their entire professional careers investing with the basic understanding that debt is cheap and bonds overall move higher.

Can you imagine what kind of impact a bond market collapse (and higher interest rates) would have on these folks? Their trading programs and algorithms were created decades AFTER the last bear market in bonds ended. They are totally unprepared for this.

If you have not taken steps to prepare your portfolio for what's to come, NOW is the time to do so BEFORE the bond bubble bursts.

Good Investing!

Graham Summers

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