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Lately I've heard increasing talk that the next big bubble that will burst in the US is the "Bond Bubble". Consider this recent Wall Street Journal article. Excerpt:

But in the same investment letter he offered a serious caution to bond investors, too. "With [long-term] Treasurys currently yielding 2.55%," [Bill Gross] wrote, "it is even more of a stretch to assume that long-term bonds—and the bond market—will replicate the performance of decades past."

[...]

Yet this has happened before. Many who warned about stocks in the 1990s were too early. Jeremy Grantham, chairman of Boston investment firm GMO, recalls losing swathes of clients before the bubble popped. Today, his firm warns against U.S. bonds, which it considers an even worse deal than stocks.

In the past five years, index funds tracking longer-term Treasury bonds have risen by a fifth or more in price. If and when the bond bull market ends, funds may retrace those steps. That would be a big fall.

The bond bubble "bursting" seems a little counter-intuitive to me, since bonds are an asset class that pay out periodically at a given rate and return principal at maturity (and therefore can't lose value as dramatically as other asset classes). That said, I understand that if bond rates go up, existing bond values go down.

So with that in mind, my questions:

  • What conditions are likely to cause the bubble to burst?
  • What would be a worst case scenario for existing bonds if the bubble did burst?
  • How would one hedge against a bond bubble bursting?
  • How would the effect of a bubble bursting affect a bond fund vs. a bond purchased directly?
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Edited the question to substantiate the OP's concerns. Cleaned up all previous comments. There are answerable parts to this question. –  Chris W. Rea Oct 16 '12 at 1:43
    
Central bank bond purchasing actions known as Operation Twist and Quantitative Easing create artificial demand in that market driving bond prices up (and interest rates lower). They will cease buying on certain dates. –  CQM Oct 16 '12 at 4:37
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Thanks Chris, much appreciated. –  Phil Sandler Oct 16 '12 at 12:53
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2 Answers

How would one hedge against a bond bubble bursting? or bearish sentiment in the bond market

You can short bonds in the bond market.

You can short bond etfs in the stock market.

You can short bond futures.

You can buy short-bond etfs in the stock market.

You can buy double and triple leveraged short-bond etfs in the stock markets.

You can buy put options on bond futures.

You can buy put options on bond etfs in the stock market.

You can buy call options on short-bond etfs in the stock market.

derivatives baby! :D

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+1. You can if you want to. Derivatives though is a very dangerous thing, and they can cause a lot of troubles on their own, as we've seen in the recent years. –  littleadv Oct 15 '12 at 3:07
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The direct losses you could experience in a bond-bubble burst (which is a real possibility but hardly a certainty) are of the following sorts:

  • Default risk. The issuer of the bond could decide not to pay you back. This isn't usually a problem for government bonds, and even when it is a problem nations in trouble have preferred to pursue some sort of restructuring or "default lite" to outright default where you lose all your principal, but loss of principal is a risk and the reason for the existence of the credit-default-swap market you may have heard about. (Greece actually restructured its debt in 2012, adversely impacting its bond holders; bondholders have also suspected that Italy, Spain, and other troubled Euro-zone nations with debt problems may pursue similar courses).
  • Interest rate risk. If you own a bond that has not yet matured (or a bond ladder or bond fund, which is continually rolling over and will always have components which have not yet matured) then when interest rates rise, you will not be able to sell the bond for as much money. This is not a problem if you hold all your bonds to maturity or hold all your bond funds indefinitely.
  • Inflation risk. Sure, you receive your money when the bond matures, but the money isn't worth as much anymore. A rapid increase in inflation is one of the most probable potential reasons you could expect bond prices to fall and interest rates to rise to begin with.

You could also experience indirect losses, in the form of reduced values of other assets like stocks, real estate, commodities, or other investments, as the broader economy feels the effects of this bubble bursting and slows down. (This is possible collateral damage from any crisis, and not of bonds in particular.) In particular, businesses which rely on borrowing money at low interest rates will be at serious risk, because lower bond values and higher bond interest rates are essentially the same thing. Businesses which are closely related to borrowed money (e.g. companies that construct houses, or banks which lend money) will also be hit.

Hedges against this sort of a bubble-burst are tricky, and depend on your goals. If you were interested in bonds to begin with it's probably because of relatively stable values and low-but-positive returns. Certain commodities might perform well in this sort of turmoil, but industrial commodities (silver, platinum, palladium, copper, etc) may suffer if the economy suffers, gold is seeing its own possible-maybe-bubble-who-knows and will undoubtedly be subject to violent price swings in times of turmoil, and commodities generally have slightly negative rates of return in the meantime while you're holding them. Cash is safe from default risk and interest rate risk, but offers limited protection from inflation risk over the long term. (In the short term, it offers you a better chance to get a better interest rate if inflation hits and rates rise.) Short-term bonds are least subject to default and interest rate risk of bonds.

If you are a long-term investor, your best bet may be equities, especially equities of companies which can best weather an economic downturn, consumer-staples and the like, and which offer dividends that could be reinvested while the stock is depressed (for greater gains later). If you have real estate and rental income in a relatively stable housing market, or if you own your own home and treat the savings on rent as an investment (a valid approach, to some extent), then it might also keep its value in an inflationary environment, but only over the long term. Actually, a fixed-rate mortgage is an effective hedge against rising interest rates and rising prices, as the debt becomes cheaper to service in real terms; when savers lose, borrowers win. But short-term losses from housing-market issues remain a possibility.

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excuse me, Italy did not do any restructuring, we paid and we are still paying all coupons. I own Italian 15 years treasury bonds at 6.5% return and I know it for sure. Whilst Greece did a major restructuring (basically a 80% default) I have a friend who owned 30K€ of Greek sovereign bonds and they give him back 6K€ with the promise to pay the remaining part in 25 years or so (that's to me it's a major restructuring, in Argentina they called it with its real name: "DEFAULT"). –  Marco Demaio Oct 16 '12 at 19:52
    
@MarcoDemaio - You are excused. I will edit this to be more clear that I was talking about not merely actual defaults but politicians and markets exploring the possibility of defaults in a variety of contexts. –  fennec Oct 16 '12 at 21:45
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