What’s a Bond Bubble and How Can You Invest to Avoid It?

If you invest money or plan to invest soon you should be aware of the likelihood of a bond bubble bursting in about 2011. Investors who don’t know how to invest to protect themselves could suffer unnecessary losses because millions of folks own bond funds. Here’s what a bond bubble is and how to avoid stepping into a mine field.

In financial lingo a bubble refers to highly inflated prices. What’s that got to do with how to invest in bonds and bond funds in 2011 and beyond? If you invest or have watched the news over the past dozen years you’ve witnessed a stock bubble and a real estate bubble. After they popped they were headline news as tens of millions of investors took heavy losses they could not afford to take. Before these bubbles burst, few investors knew they even existed. Heads up if you invest in bond funds!

If you invest at all or pay attention to the news you already know what happens in real estate and stocks when prices go to extremes. There is good reason to believe that as 2011 unfolds that the next big financial headlines will be about a bond bubble. I say this because bond prices are extremely high. Investors have chased bonds and bid prices to extremes because bonds and the bond funds that invest in them pay higher interest than you can get elsewhere. Plus, our government plans to invest in (buy) more of its own bonds and notes to force interest rates even lower (and bond prices higher).

Bonds are simply long term debt obligations that trade in the open hult private capital reviews market like stocks do after they are initially issued. They are issued (sold to investors) by the U.S. government, corporations and municipalities who want to borrow money for the likes of 10 to 30 years at a fixed interest rate. Hence, when you invest in bonds you are lending these institutions money. Here’s an example of how it works. XYZ sells bonds to the public priced at $1000 paying 7% a year in interest. Let’s say that a few years later interest rates across the board fall to record lows with 1-yr CDs paying about ½%. What would happen to the price (value) of XYZ bonds?

Very simply, the price would go up significantly since XYZ still pays 7% or $70 a year in interest. Who wouldn’t want to invest and earn 7% these days? The problem is that if you invest at the new higher price it would cost considerably more than $1000 to earn that $70 a year in interest. As an extreme example, if you pay $2000 for XYZ bonds you only earn 3.5% on your money. In other words, high bond prices go hand in hand with low interest rates. And low interest rates mean high bond prices.

Today’s interest rates are flirting with all-time lows. That’s why I see a potential bond bubble in 2011 or further down the road. If you don’t know how to invest to protect yourself you might be surprised by heavy losses in your bond fund(s). I say this because when interest rates reverse and head back up some day, bond prices will fall as investors scramble to SELL bonds. After all, if you could get 2%, 3%, maybe 5% on a 1-year CD with high safety as 20ll and the future unfolds… bonds and bond funds would look less attractive wouldn’t they? When investors SELL heavily in any market prices fall out of bed. If you invest in bonds or bond funds before rates go up you will lose money and continue to as long as rates climb. Period. That’s the way bond investing works.

Here’s how to invest to protect yourself in 2011 and beyond. Average investors should continue to invest in bond funds as part of their long term investment strategy. But don’t load up on them as millions of folks have recently. If anything, cut back on bond funds and increase your holdings in safe money market funds. Then make sure to invest in intermediate-term bond funds vs. long-term bond funds. Invest in funds with an average maturity of about 5 years and dump any bond funds you have with average maturities of 10 years or higher. Shorter-term bond funds are much less affected when interest rates go up.

If you invest in long-term bond funds and a bond bubble bursts in 2011 or later you will take significant losses. If the bond bubble continues to grow throughout 2011 and maybe 2012 and then pops… it could be another financial crisis. Hopefully the bubble doesn’t burst at all. Just in case, it’s best to know how to invest to avoid heavy losses if it does.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

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