Put 100 investors in a room and most will tell you how worried they are that the still-bullish U.S. stock market is going to betray them for a third time in slightly more than a decade.

But I submit that it’s the bonds that these folks are right now holding that should be the real focus of their concern – and for one very good reason: Most investors view the global bond market as a stodgy source of fixed income, when it’s actually the largest, most complex and most sensitive capital market in the world today.

A High-Risk “Safe Haven”

Bondholders should understand two key facts about the market that they are relying on for income. I believe, not coincidentally, the following two facts also represent the biggest risks that bondholders currently face:

  • First, the global bond market is estimated by some to be worth more than $80 trillion, with the U.S. portion accounting for about $31 trillion to $34 trillion. That means that the global bond market dwarfs its stock-market counterpart, which has a global capitalization of about $55 trillion (of which roughly $15 trillion is U.S.-based). Why is that key? A market that large and that dominant means that it’s controlled and closely watched by big institutions and central bankers – and not necessarily in that order. Those institutions are sensitive to any market changes – and react accordingly ( the same can be said about central bankers, even though they are not necessarily direct “players”). All of this makes the bond market a volatile and potentially dangerous place for investors who aren’t following along.
  • Second, the bond market is highly reactive to interest-rate changes – both actual and anticipated. And the increase in interest rates that’s headed our way due to growing inflationary pressures will have a huge impact on bond prices, which move opposite interest rates. Investors who don’t understand the potential risks – and who haven’t made the appropriate adjustments to their bond holdings – will experience pain that far exceeds the fallout from previous stock-market downturns. And since so many investors perceive the bond market as a financial “safe haven,” I would argue that the percentage of bondholders who fall into this category is much larger than most realize.

Growing Exposure

[ad#Google Adsense]To see how this risk has escalated, let’s talk about money flows.

Since 2009, more than $1 trillion has flowed into bond mutual funds. That’s more than all the money that flowed into stock funds throughout the entire “dot-bomb” bubble of 1998-2000.

And we all remember how that ended.

If that doesn’t get your attention, perhaps this will.

According to the Investment Company Institute (ICI), the trade association for investment firms, bond funds that invest for safety, income and higher returns (translate that to mean investments in domestic government bonds, investment-grade U.S. corporate bonds, and “junk bonds”) – attracted more than $409 billion in 2009 and 2010. That’s more than bond funds investing in the three areas I just pointed out attracted in the 10 previous years put together.

Part of the increased money flows into bond funds was due to the global financial crisis and simple fears that things might get worse. But, surprisingly, greed was a major catalyst, too.

The fear factor is easy to understand because bonds are perceived as being less risky than stocks. That perception is especially true for government bonds – and, most specifically, U.S. Treasuries – the popularity of which is based on the implicit assumption that the U.S. government will not default on its obligations, or fail outright.

One prominent group of gloom-and-doomers predicted that we’d see virulent inflation once the economic recovery really got going. That would force central bankers – including the U.S. Federal Reserve – to sharply push up interest rates. The result: Bond prices would crater.

But just the opposite happened. We entered a double-dip downturn, which forced the Fed to slash rates – and to hold them there for an extended stretch that continues today – at least officially, anyway. The deeper rates declined, the higher bond prices surged. Those ingredients – with the Fed’s “no pain/all gain” philosophy serving as the fuel – ignited a bull market in bonds that PIMCO Chief Investment Officer William H. “Bill” Gross described as the most “brazen of all ponzi schemes.”

That’s all history, though. What’s important to understand is what’s ahead. And I see an entirely new scenario taking shape – one that investors need to understand and ready themselves for.

Looming Battle

The stage is set for a battle royale over U.S. President Barack Obama’s new fiscal budget plan, and badly needed austerity measures that should be part of the solution. While the exact fallout has yet to be determined, one of the most likely results is that interest rates are likely to head higher much sooner than the “experts” expect.

In fact, it’s already happening.

When the second round of quantitative easing – the so-called “QE2” – was announced, the key justification was that this new initiative would help hold down interest rates. In fact, interest rates have actually advanced 16.73% on the benchmark 10-year U.S. Treasury note, putting it at 3.055%.

As Carl Kaufman, head of fixed-income strategy at Osterweis Capital Management, told Money magazine: “Loading up on Treasuries now is sort of like buying Internet stocks in early 1999. The game at this point is, ‘Let’s see if there’s still time to sell to the greater fool before the music stops’.”

I couldn’t agree more.

Indeed, that’s why I’m right now so concerned that somebody’s going to yank on the tail of the bond-market bull.

And the result of such an action is pretty easy to picture.

Moves to Make Now

The scenario that I’ve sketched out is going to happen … the only question is “when?”

Here’s how to make sure that you don’t get trampled.

  1. If you’re in the bond markets for safety, consider diversifying into broader ranges of bonds and shortening up on your duration. In terms of duration , I think the “sweet spot” is about five years or less, right now: That’s short enough to keep you safe, while also offering the ability to reinvest in higher-rate paper without getting hit too badly as rates begin to rise. Shorter duration also helps to dampen the overall volatility of your bond portfolio, because it makes your holdings less sensitive to chaos and, more specifically, to increases in interest rates.
  2. If you’re in the bond market for income, consider buying emerging-market bonds and foreign-government paper. Here, too (and for the same reasons cited in the preceding point ), cap your duration at five years or less.

Search for investment vehicles that meet your overall investment-plan objectives for timing, risk, income and share (of your overall portfolio). Here are three investments to consider as part of that search:

  • Treasury Inflation Protected Securities (known as “TIPS,” for short): TIPS are indexed to the U.S. government’s official consumer-price-index (CPI) figures. As we’ve explained many times to you and our other Money Morning readers, the official CPI numbers are complete poppycock. Even so, they form the basis of many other calculations made by the government. And the CPI will start to move in earnest as the inflation that’s already here begins to work its way through the economy. TIPS should appreciate markedly as that happens. But be prepared to hold to maturity, because that’s how you’ll insulate yourself from the near-term bond-market swings that are a function of interest-rate indecision, central-banker missteps and the growing Middle Eastern firestorm that will artificially prop them up a bit longer.
  • PIMCO Strategic Global Government Fund (NYSE: RCS): This fund not only boasts a hefty 8.5% yield, it invests in government paper that can help you diversify away from the risks posed by U.S.-only instruments. Right now, the fund is concentrated in U.S. paper – with the bulk of the holdings concentrated in U.S.-backed government securities and corporate bonds. However, 5% of the fund is invested in overseas paper. And the fund managers have the investment mandate – and, more importantly, the ability – to move offshore to other holdings if they want. This capability will be key if – and more likely, when – the U.S. government changes its mind about propping up the financial house of cards that it’s built.
  • Rydex Inverse Government Long Bond Strategy Fund (RYJUX): As rates rise and bond prices fall, this “inverse fund” should appreciate significantly. It’s taking a little while to “take off,” but that’s not a function of the fund. Instead, it’s simply the fact that Team Fed is playing against you. For now, Team Fed is winning. But don’t expect that to continue for much longer.

— Keith Fitz-Gerald

Source:  Money Morning