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Welcome to the Bubble (or, Bonds or Bust).

The cries warning us about a so-called bond bubble have been rising ever more loudly from the street. Sages warn us that there is more upside risk to interest rates than downside reward. No kidding? Did these financial oracles figure this all out on their own? With the Fed funds rates effectively at zero and the 10-year note hovering around 2.50% it doesn’t take a rocket scientist or someone with supernatural gifts to draw that conclusion. However, low rates do not a bubble make.

A bubble occurs when investors pile into an asset class, market, etc. irrationally. When calmer heads prevail and profit-taking begins, the bubble bursts. However, there is nothing irrational about today’s interest rate levels. Inflation is relatively tame. Job growth is lackluster. Banks are disincentivized to lend for both economic and political reasons. Consumers are still over-leveraged. What in the world, outside an exodus from the dollar by investors large and small, would push rates higher at this time? The answer is nothing, yet.

The truth is that the ability for investors to exit the dollar en masse is limited. Consider this: Gold hits a new high nearly every day. Some foreign central banks are actively, if not desperately, trying to halt the rise of their currencies. Yet long-term U.S. rates remain historically very low. Some of this can be attributed to quantitative easing and the threat of QE2, but it is more about the reasons why more QE may be necessary, not the QE itself, which is keeping rates low on the long end of the curve.

What are the reasons the Fed believes more QE may be necessary?

1). Consumers are not borrowing. It is true many are simply over leveraged and cannot borrow, but many do have access for credit but see little need to borrow. The Fed hopes to keep rates low to entice those who can obtain credit to come off of the sidelines. (If not push rates lower as has happened since the threat of more QE was announced.)

2) Businesses benefit from low borrowing costs. U.S. corporations have flooded the market with new debt. Large bond deals have come to market almost every day for the past several months. This cheap source of borrowed funds, which provide debt service expense savings, have contributed to stronger balance sheets and higher profits. If consumers spend less and business activity is modest, the Fed has helped make the transactions which do occur, more profitable. This is evidenced by the Durable Goods, GDP and regional business activity reports; that businesses are using this cheap source of funds to buy new, more efficient equipment. However, this does little for hiring.

Some economists have pointed out that increased hiring has always followed such spending. This may again be true, but the hiring which does take place may be smaller in scale than in the past. It might pay lower wages than to what workers have become accustomed and may be created offshore.

3) The third reason is policy-driven economic headwinds. Higher business and personal taxes, unclear effects of new healthcare legislation* and concern among banks as to what their capital requirements will be along with anti-business rhetoric from the Obama administration; all are doing much to dampen growth. (*Apparently Health and Human Services Secretary Kathleen Sebelius will have a good amount of discretion to decide which corporate health plans are acceptable and which are not. 'It is good to be the queen'.)

Businesses don’t have to hire. Consumers don’t have to spend beyond sustenance levels and banks do not have to lend if the reward of doing so does not justify the risk. No amount of Capitol Hill bluster is going to change that. Many pundits have pointed to one of my aforementioned reasons, but it is truly all three which are responsible for the disappointing recovery.

The upshot of this is that rates will stay low for an extended period of time. Cash is not the place to wait as rates are punitively low. The long end of the curve is not an optimal destination because a 100 basis point rise in long-term rates could result in 10+ point price declines on bonds.

Alternatives: laddering

There are ways to soften the blow of rising rates without holding cash with very little yield. One can ladder. Not all areas of the curve lose value in the same fashion. Like everything in life, investing is about balance. While a 30-year bond may lose 12 points worth or principal value for a 100 basis point rise in rates, a 10-year bond may lose 7 points, a 5-year bond 3 points and a 2-year bond only one point. By laddering a bond portfolio, one can possibly focus on the so-called belly of the curve (5 to 7 years out), usually the most stable in a changing rate environment. One can obtain decent yields without taking on excessive interest rate volatility.

One should also understand that not all bonds react the same way to changing interest rates. Some bonds, such as U.S. Treasuries, are interest rate products. Where rates go, they go (the Fed influences the short end while inflation expectations influence the long end). However, some bonds, such as corporate bonds, are credit products. Although interest rates can affect their trading levels, their credit spreads versus Treasury benchmarks also play a part. The changing of credit spreads due to balance sheet strength or weakness and investor demand for portfolio diversification can affect credit spreads.

We have seen this in action. In the extreme, we saw yields for bank and finance bonds rise in 2008 and early 2009, even though Treasury yields fell. Their credit spreads widened due to balance sheet and viability concerns. Their yields did not follow interest rates. Once it became apparent that the largest banks were not going to fail, their credit spreads narrowed (to a point) and their yields fell more than Treasury yields for a period of time. Less volatile sectors such as utilities and companies in the consumer product sectors did not experience such spread widening and flowed Treasury yields lower. This would often outpace the drop in rates as credit spreads narrowed. Investors looking for yield sold their bank bonds and purchased utility or industrial sector bonds, hoping to get even a small yield pickup over Treasuries.

Rising interest rates may be offset somewhat by purchasing bonds which are trading at credit spreads still wider than their historic norms. This leads us back to the banks. Bonds of the large money center banks and large regional banks are still trading wide to Treasuries. In some cases 50 to 100 basis points wider. If rates rise due to an economic recovery, these credit spreads could narrow 50 to 100 basis points, effectively offsetting the first 50 to 100 basis point rise in long-term rates.

However, the story could be very different for bonds in other sectors. In an effort to earn returns above Treasuries, but take on minimal risk, many investors purchased bonds in less volatile sectors and companies. If rates rise due to improving economic conditions, investors may sell their bonds trading at very tight spreads (Microsoft (NASDAQ:MSFT), Wal-Mart (NYSE:WMT), Johnson & Johnson (NYSE:JNJ), etc.) and buy bonds in sectors or companies that were, until now, a bit to risky for their tastes. Compaines like Bank of America (NYSE:BAC), Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), etc.. For this reason, the yields of industrial sector bonds could rise even faster and more sharply than Treasury yields as their safety is no longer needed.

When investing in fixed income one must understand the mechanics of the various products. By mixing in credit products with interest rate products and spreading one's assets across the curve, one can earn attractive returns without being blown up by any bursting “bubbles”. Only out to10 years or so, as one can pick up 75% of the slope of the curve without incurring the volatility of the very long end of the curve.

I forgot to mention: Preferreds are rich and floater bonds do not necessarily protect you from rising rates. It all depends on how much they float, off of what benchmark they float and off of what benchmark they trade.

Disclosure: No positions

Source: Laddering Bond Portfolios: The Alternative to Bursting Bubbles