Jeremy Siegel author of Stocks for the Long Run recently wrote an op-ed in the Wall Street Journal titled “The Great American Bond Bubble”. Siegel stated that bonds are the ultimate bubble comparing them to the tech bubble before it burst in 2000.

Siegel quoted some interesting facts in his op-ed. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows. This is the first bad signs for bond holders. When everyone is buying bonds that is not the time you want to buy.

bond market bubbleI want to focus on the arguments in regards to long term bonds since they are the most volatile.  Ten year treasury bonds currently yield a paltry 2.60%. If the yield goes up to 4% which it did several months ago, investors will lose about 10% of their principal. In all likelihood the yield will go much higher than that. I have argued in previous articles that the normal Fed funds rate is at least 4% in normal economic conditions. If the Fed raises interest rates to 4% ten year treasury bills will be yielding closer to 5 or 6%. It is possible the Fed funds rate will go even higher, that is most likely the minimum level it will reach.

In addition, inflation has averaged about 3% over the past several decades. When you compound 3% for ten years while you are only earning 2.6%, you have real returns that are negative. However, it is likely that inflation will be far higher in the future. The mixture of the Fed’s quantitative easing, and the huge budget deficits that are running as far as the eye could see might bring the return of hyper inflation in the next ten years. Warren Buffett is one of those investors who are preparing himself for hyperinflation, by shortening the length of the bonds he holds. In the early 1980s we had inflation in the double digits, and there is no telling whether this will happen again.

Another point that must be considered is the bond to equity relationship. Right now the Dow Jones components have an earnings yield of slightly about 7%, when you throw in the dividend yield of above 3% which equals a total yield of 10%. This is nearly four times as much as the ten year is yielding

The Pragmatic Capitalist recently wrote an article which argued that we are not in a bond bubble. He argues that it is incorrect to call bonds a bubble since it does not match the technical definition. However, regardless of whether it is technically a bubble or not long term bonds seem to be an awful investment choice.

He further argues that the bond auctions are always oversubscribed. This is true however they are oversubscribed because the market likes the rate the bonds are sold at. The bond auctions were oversubscribed when the 10 year reached a yield of 4% earlier this year, and it is oversubscribed now when the yield is 2.60%. So without getting into the topic of whether bond auctions can ever be undersubscribed it is important to realize that yields can and will rise regardless.

One other point he brings up is that one can hold the bonds till maturity and incur no loss on principal. This is a good point because this differentiates stocks from bonds, and the current state of bonds from the tech bubble. However, despite the valid point, it still does not mean buying ten years at 2.60% yield makes sense. If six month CDs are yielding 8% in five years from now, you do not want to be holding onto a 2.60% ten year bond. Even if you will lose no principal if you hold until maturity, you will still be locked in at a low rate. This is almost akin to getting a fixed rate mortgage in the early 1980s at around 20%.

The only argument bond bulls have going for them is the Japanese experience. Japan has had low interest rates for nearly 20 years, and low rates on Government bonds. Despite all the predictions of bonds being a bubble they turned out to be a far better investment than Japanese equities.

However, the Japanese experience is unique. I am no expert on the history of international bond yields, but it seems that this is the only case where bond yields stayed so low for so long. So Japan was really an anomaly, and it is highly unlikely this will occur in the US.

So how does an investor take advantage of the situation in the bond market? If you are a bull you can purchase TLH and TLT, which are both long term treasury ETFs. If you are a bear like me you can short them. In addition, there are several long term treasury short ETFs. TBT is a leveraged short long term treasury bond ETF. However, I stay clear of the leveraged ETFs as they do not correlate well to the underlying asset. A better way to short long term bonds is through the purchase of the mutual fund symbol RYJUX.

Many people argue it is impossible to see a bubble until after it bursts. While bonds are not a bubble per say, they are an awful investment currently. No one can claim in hindsight that there was no way of knowing.

Disclosure: I am short long term bonds through the mutual fund ticket RYJUX