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When Warren Buffet says that bonds "are among the most dangerous of assets," people take notice. And that goes double when Laurence Fink, CEO of Blackrock, says that investors should be 100% in equities.

Their comments are evidence of a growing sentiment that bond prices have formed a bubble that is ready to pop. Just a few days ago, Eric St-Cyr, founder and CEO of Clover Asset Management, wrote an article for Marketwatch.com titled "Is the Bond Bubble about to Pop?," in which he advocated selling sovereigns immediately and keeping a close eye on corporates.

The question is, if the bond bubble pops, how bad will it be? More important, what should you do? While conducting research on this topic, I came across a partial answer to the first question and an surprising suggestion regarding the second.

The analysis presented here is part of a broader study to be published later. In this piece I will focus on the effects of rising interest rates on two of the most widely held bond market index ETFs, AGG and BND. Together these two giants have combined assets of almost $30 billion. Many investors rely on them as the core holdings for the fixed income portion of their portfolios. If they go down hard, a lot of people will get hurt.

To assess the risk to these two ETFs, I looked for episodes of rapidly rising interest rates in the recent past that might allow us to quantify the possible dangers. I found one in the four-month period between 10/8/2010 and 2/8/2011, when the CBOE 10-Year Treasury Note Index (TNX) showed an increase corresponding to a rise in 10-year rates from 2.38% to 3.72% (source: Yahoo Finance) or 134 basis points (1.34%). This increase may have been associated with the anticipation and public announcement of QE2 on 11/3/10, but the reasons for the rise are less important to us than the results.

How bad was the damage? Over this four month period the long Treasury bond ETF TLT declined 9.65%. AGG and BND, which hold bonds of much shorter average maturity than TLT, went down 3.09% and 3.02%, respectively.

But now suppose that this increase continued at the same rate for a whole year. That is, suppose that 10-year interest rates went up 402 basis points (4.02%) in one year. In practical terms, suppose that a year from today, 10-year rates were at 6%. What would the damage be then? Extrapolating from the data presented above (i.e., multiplying by 3), TLT would be down almost 29% and AGG and BND down 9.27% and 9.06%, respectively. That would represent a decline in market price equivalent to 3-1/4 years' interest for AGG at its current yield (2.84%) and just under 3 years' interest for BND at its current yield (3.08%).

Would you sell AGG or BND today if you knew for sure that both ETFs would lose over 9% in the coming 12 months? Or would you hold on for the long haul? That's up to you to decide. But supposing you did sell, what should you buy instead? The surprising answer: junk bonds. At least, that's what the data from late 2010 to early 2011 indicate.

While TLT, AGG, and BND were losing value between 10/8/2010 and 2/8/2011, JNK and HYG were big gainers: up 5.32% for JNK and 5.53% for HYG. On an annualized basis (multiply by 3), that's more than 16% each. Why did this happen? Perhaps because the anticipation of QE2 stimulating the economy reduced worries about deflation and a double-dip recession, which in turn suggested that the companies that issue high-yield debt were less likely to go bankrupt and default on their bonds.

But would anybody seriously consider selling AGG and BND to buy JNK and HYG? The answer may be yes, if you believe a recent story that appeared in the WSJ, with the title, "Buyers Take a Shine to 'Junk'," which reported that:

"Retail investors have plowed $11.8 billion into junk-bond mutual funds this year, compared with $4.8 billion for stock funds and $9.9 billion for investment-grade bond funds, according to research firm Lipper. Mutual-fund managers say they are also increasingly buying up junk bonds, or bonds of companies with below-investment-grade credit ratings."

Should investors who own AGG and BND do this? I don't know and certainly don't presume to made any recommendations. At the very least, however, the trade is intriguing.

Disclosure: I am long BND.

Disclaimer: The analysis contained in this article is for informational purposes only and does not constitute a recommendation to buy or sell any security. Do your own research and due diligence. Good luck!

Source: Sell Bond Index ETFs, Buy Junk Bonds Instead