Beware of the Bond Bubble

NEW YORK ( TheStreet) -- It's ironic that while pundits and politicians are fulminating about our nation's debt crisis, the top-performing asset class in our public financial markets has been U.S. debt securities.

Other countries facing a debt crisis have seen the value of their bond issues drop as investors grow concerned about the risk of default and buyers of the bonds demand a higher yield to compensate them for taking that risk.

The U.S., however, is a different animal. On the day Standard & Poor's cut its triple-A credit rating last summer, the value of U.S. Treasury bonds actually rose in spite of the country's political gridlock, its spiraling entitlement costs, its foreboding demographic trends, its total debt that now amounts to more than $15 trillion (over 103% of GDP), and its annual budget deficit approaching $1.5 trillion.

Despite this precarious fiscal position, the market doesn't look worried about a U.S. debt default -- and with good reason. For all its problems, the U.S. remains a wealthy nation, and its economy is in relatively good shape compared to the rest of the developed world. Moreover, it enjoys the privileged position of printing the world's reserve currency, the almighty greenback. This cuts the country plenty of slack to run up debts and print dollars to stimulate its economy and meet its obligations, and that's what it has done.

Now, the yield on the 10-year Treasury bond -- the investment world's benchmark for a risk-free return rate -- has set record lows as global economic devastation threatens. Investors, still feeling the burn of 2008's financial collapse, are fleeing the volatility of the stock market for the promise of capital preservation in Treasuries and other fixed income assets.

For some investors, Treasuries and other bonds are certainly appropriate, and most investors should have some allocation to fixed income in their portfolio. But many of those piling into the bond market, particularly Treasuries, are now are making a mistake. Treasury bonds are in the midst of the market's latest asset bubble, which will pop sooner or later.

At this point, some readers may be thinking, "Hey, I've been hearing this argument about Treasuries for a while, but it keeps turning out to be wrong. Yields keep going lower, and bond prices keep rising." True, but that's the nature of an asset bubble. They're caused by a perfect storm of events that allows them to keep ballooning, appearing to prove the skeptics wrong and winning new converts. That's what makes them so dangerous.

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