"Is your portfolio adequately protected from rising interest rates and a bond bubble?"
I posed that question to my readers just a few weeks ago. And the responses -- while not surprising -- were certainly concerning. That's because 60% of my readers responded by saying that they were either not protected from rising interest rates, or that they did not know how their investments would weather a "bond bubble."
And that concerns me. I suspect that even the 40% of my readers who believe they are protected from a bond bubble may face considerable losses if and when interest rates start rising. That's because the days of owning U.S. Treasuries and storing them in your safe deposit box are long gone. With the advent of mutual funds and more recently ETFs, investors now own most bonds through funds.
There are, of course, bond funds like the iShares Barclays 7-10 Year Treasury (NYSEARCA:IEF). And as the name suggests, the fund invests directly in U.S. Treasuries bonds with maturities of seven to 10 years. Now, avoiding a U.S. Treasury fund like the iShares is easy to do -- just look no further than the name. But there are many diversified bond funds that also have considerable exposure to long duration U.S. government bonds.
Consider the Vanguard Total Bond Market ETF (NYSEARCA:BND). This fund manages $110 billion in investments. Vanguard is a great investment manager, but this fund is mandated to invest in bonds. With 44% of its assets invested in U.S. Treasuries and government agency bonds, investors in this fund have a big stake in U.S. government debt.
Vanguard isn't the only fund company with a big stake in U.S. Treasuries. Almost every bond fund owns U.S. Treasuries. You know that I'm not someone to promote doom and gloom. I'm an optimist who believes that America's economic recover continues to slowly unfold. And I see bright days ahead for the U.S. economy and the stock market.
Let me be clear about the bond bubble. I don't believe that the U.S. government is going to default on its debt payments. I simply believe that we're in the early stages of a rising interest rate environment. As interest rates rise, bond values will fall. Bond investors who hold their bonds to maturity can expect to be paid out 100% of their principal.
But investors in bond funds can't hold the fund to maturity, since funds always roll over maturing bonds to buy new bonds. As a result, anyone holding a bond fund -- or even an ETF that holds Treasuries (many of them do) -- will experience very real losses as bond prices fall. Ever since Fed Chairman Ben Bernanke suggested a slowdown in bond buying -- also known as tapering -- yields soared while values fell. For example, the yield on the 10-year U.S. Treasury jumped 64% since May.
The decline in bond funds already started. The Vanguard fund I mentioned fell 5% since May. And the Barclays Treasury fund is down 8%. The riskiest bonds are those with longer maturities. These losses may seem small, but they have investors fleeing from bond funds. Last week alone, investors withdrew $11 billion from bond mutual funds. And since the end of May, outflows totaled $97 billion.
But remember these losses and outflows happened based on the idea that the Fed might slow down its $80 billion per month bond buying program (also known as QE3). What will happen when the Fed actually follows through on its threats? Or when the Fed stops buying bonds altogether? Or when the government actually increases interest rates to attract investors to U.S. Treasuries?
Today we are in uncharted territory. With Ben Bernake stepping down as Chairman, the future actions at the Fed remain uncertain. I firmly believe this bond story is the single biggest issue that will impact investments in the coming years.