How to prepare for the bond bubble bursting

Human beings aren't very good at predicting the future. But that doesn't stop lots of people from trying. Every January, the financial pages are full of forecasts on where to put your money for the year ahead.

There's nothing wrong with this. But this year, I find myself asking a very different question: is there anywhere left to invest?

That might sound odd. There are plenty of places where private investors can put their money these days.

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But are they really investing? Or are they just taking a punt?

Are we all speculators now?

To me, the best definition of investing' is still the one given by legendary value investor Benjamin Graham in his book, The Intelligent Investor: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

Put another way, you have to buy assets that will give you a decent income return and at the same time are cheap enough so that you are unlikely to lose much money if it goes wrong. This advice tends to steer investors towards assets that are beaten up and have been shunned by the masses. The stock market in 1982, early 2003, and early 2009 are good examples. Gold at $250 per ounce in 2001 is another example.

My problem is that, looking around the markets today, I struggle to find any asset classes that qualify as decent investments on these grounds. Sure, there are individual opportunities within each asset class there always are.

But yields on many government bonds are below inflation, stocks on the whole are hardly cheap by historical standards, gold yields nothing (at this level, I see it as insurance, rather than a value investment), and property in most markets looks expensive.

It seems to me that almost regardless of where you put your money, Graham would class you as a speculator, rather than an investor. How have we ended up at this point?

Investors are sitting in a minefield

It starts with the most overvalued market out there the bond market. Investors have been buying bonds by the bucket load. This is partly due to fear. They are happy to sacrifice the prospect of any reasonable return in most cases, the return will be negative (below inflation) in exchange for the comfort of knowing they will get their money back when the bond matures.

However, the bond markets have also been heavily manipulated by central banks printing money to bail out cash-strapped governments and fragile banking systems. With Bank of England boss Mervyn King and the Federal Reserve's Ben Bernanke acting as a backstop to the bond market, investors have been lulled into a false sense of security. They think that the bond market simply can't crash.

These artificially low rates on bonds have in turn chased other investors into riskier assets such as stocks. Last year was a good year for shares. The FTSE All Share index returned 12.9%, while the S&P 500 returned 16%. The momentum has carried on in to the new year. But shares are not cheap either.

The FTSE All Share currently trades on 16.3 times trailing earnings, the FTSE 250 on 20 times and the S&P 500 on 14.8 times. These are not the sorts of valuations that bull markets start from. Arguably, company profits need to keep going up for these prices to make sense. And this is by no means certain given the weakness of many economies.

In short, bonds are desperately expensive, and shares are certainly not cheap. These sorts of valuations suggest that investors have become too complacent. So what could shake them up?

When will the bond market blow up?

History tells us that bond markets can and do crash. It happened in the US in both 1979 and in 1994. When bond prices crash, yields rise. When yields on bonds rise, the income stream such as dividends - from other, riskier investment assets has to rise too, so that they remain attractive. After all, why would you buy a stock paying a dividend of 3% if you could buy a safe' bond paying 8%?

This means that if bonds crash, equities are likely to fall too. At the moment, I think the UK and US government bond markets resemble an active volcano. Near-record low yields and a heavily manipulated market, dominated by one big buyer, are a recipe for trouble. When it blows, there will be few places to hide.

In both the UK and the US, bond yields have spiked higher this year (see below for the UK). Does this represent a build-up in pressure before an almighty eruption?

UK ten-year bond yield

The bond market can move very quickly in response to bad news. An unexpected rise in interest rates or inflation is usually what spooks the market. This time round, it might be that the market runs short of buyers.

Last week, the yield on the ten-year US government bond rose sharply as the market fretted that the Fed's latest bout of quantitative easing (QE) which involves buying $85bn of bonds every month might end sooner than investors had thought. UK bond yields shot up in sympathy.

This should serve as a stark warning. When the chief manipulators of the bond market stop buying, prices will have to find a natural level. I don't know what that level is, but my guess is that bond yields will be a lot higher than they are now.

Since 1956, yields on UK ten-year government bonds have averaged 2.2% more than inflation (as measured by the retail prices index). If yields were to normalise to this level today, they would be above 5%. Investors in long-term bonds could lose a lot of money, whilst assets like shares, which might look relatively cheap now, would look a lot less attractive.

More importantly, borrowing costs across the rest of the economy including mortages would have to go a lot higher, which would more than likely hurt the earnings of most companies as disposable incomes fell.

What to do with your money

Low bonds yields are a trap for investors. They make it hard to invest sensibly for income and for retirement without taking on too much risk. Like the market in internet stocks in the late 1990s, bonds today are a bubble. One day this bubble will burst with potentially disastrous results for our savings. Indeed, regular MoneyWeek contributor James Ferguson reckons that QE could end in the US as early as this year (see our New Year roundtable for more if you're not already a subscriber, subscribe to MoneyWeek magazine).

Yet the trouble is, the current situation has been with us for some time and could go on for a while yet. So as I can't predict the future, I'm not saying that you should sell all your shares, bonds or property. But it does make sense to get some protection in your portfolio. You can do this by rebalancing your portfolio: perhaps by taking some profits on shares that have gone up, limiting your exposure to bonds, and putting some money into safer assets.

What safer assets? Well, as I wrote a few weeks ago, I think there's a good case for making cash an integral part of your portfolio. And if you must hold bonds, then holding short-dated ones (with maturities of less than five years) in spite of their miniscule yields will prove to be quite defensive if the bond market cracks. The iShares FTSE UK Gilts 0-5 years ETF (LSE: IGLS) could be an option for your portfolio.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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