A Bear Market in Bonds Will Come, Eventually

NEW YORK (TheStreet) -- The U.S. stock market has obviously been making new highs as bond yields have been making new lows.

The big catalyst behind these good times, it could be argued, has been the nonstop purchase of assets by the U.S. Federal Reserve and its zero-percent interest rate policy. All of this is having the effect of pushing investors into riskier assets to get a "normal" yield/total return.

This action by the Fed is unprecedented and is distorting market prices and fixed income yields. Barron's pointed out that for the first time ever, junk bond yields as measured by the iShares iBoxx High Yield Corporate Bond ETF ( HYG) went below 5%.

This past January was the first time junk bond yields went below 6%. For a little perspective, in the summer of 2006 two-year U.S. Treasurys could be bought with a 5% yield. That was certainly a different time but it speaks to the idea that investors are being squeezed to find yield.

Junk bond yields below 5% is an indication the bonds are expensive and the market is not properly pricing the risk taken by investing in this part of the market. The PowerShares Fundamental High Yield Bond Portfolio ( PHB) might be even more expensive than HYG, the information page at the PowerShares Web site for this fund shows the trailing 12-month yield at just 4.77%.

This circles back to proper diversification and not over-reaching for yield. A diversified bond portfolio includes some exposure to riskier bonds or bond funds but too much exposure to risky assets at the wrong time ultimately ends badly; tech stocks 13 years ago and bank stocks six years ago and riskier fixed income products will not be an exception.

Many will argue that although bonds are overpriced, they are not likely to go down soon because the Fed is continuing to buy assets and will likely keep rates at zero percent until at least 2015. The flaw in this argument is the assumption that everyone will know when the bull market in bonds is ending and will all be able to exit calmly.

Typical of bear markets, the end to the current bull market in bonds will come about in such a way as to not be reasonably forecasted by many people.

Instead of trying to predict the unpredictable, investors would be better served having smaller portfolio weightings to more bond market segments that don't all assume the same type of risk. Funds like HYG and PHB mentioned above take credit risk, which is risk that bonds in the funds will default.

A fund like the Pimco Australia Bond Index ETF ( AUD), which owns sovereign debt, takes currency risk but not credit risk. A fund like the Guggenheim BulletShares 2020 Corporate Bond ETF ( BSCK) takes interest rate risk, which is the risk that the prices of the bonds in the fund will go down when interest rates go up.

All the funds have decent yields while taking different kinds of risks and, of course, there are more than three segments available from which to build a bond portfolio.

No one knows what a bond bear market will look like or what areas will be most affected. A strategy of combining different risk profiles will not guarantee success but gives a good chance of not having too much in market segment that gets hit the most.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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