[The following commentary is from the latest issue of the Weekend Update (Volume V, Issue 34) at Iacono Research. For subscription details, click here.]

The increasing amount of commentary on the subject of whether or not the world now faces a “bond bubble” combined with a recent article detailing the poor performance of inverse bond funds in 2010 seemed like sufficient justification to revisit a topic that was discussed here three weeks ago when I took “A Quick Look at Rising Rate Funds” (see Volume V, Issue 31).

Recall that, in the referenced discussion topic, short-term and long-term charts of Treasury yields were shown, in which it is clear to see that interest rates rose for decades to a peak in the early 1980s and have retreated from there to what now appears to be the end of another secular trend. Also, 13 inverse bond funds were presented in table form with the following three being suggested as likely candidates for the model portfolio when the time is right:

• Profunds Rising Rates Opportunity 10 (RTPIX)
• Rydex Inverse Government Long Bond Strategy (RYJUX)
• ProShares Short 20+ Year Treasury (TBF)

Obviously, as should be clear when looking at the graphic below, the time has not been right over the last four months because all three of these “unleveraged” funds – a key consideration for a position that may be held in the model portfolio for a very long time – have been big losers. Funds that apply leverage of between 1.25x and 3x have done much worse than the 1x funds, in some cases the year-to-date losses exceeding 40 percent.

[Note: While I haven't looked into the discrepancy in performance between RTPIX and both RYJUX and TBF as shown above, it is likely the result of the former being based on the 10-year Treasury and both of the latter being derived from longer dated U.S. debt. The fact that the 1.25x leveraged Profunds Rising Rates Opportunity (RRPIX) is based on 30-year Treasuries and it has done worse than either RYJUX and TBF so far this year would seem to confirm that this is the reason, something that will be looked at more closely prior to actually purchasing one or more of these funds.]

In any event, this MarketWatch report from not long ago showed a similar performance chart and lamented the wrong guesses that many investors made earlier in the year.

It has been, without question, one of the biggest financial stories of the year – bond prices that began soaring in May as stocks sold off, pushing the iShares Barclays 20+ Year Treasury Bond (TLT) to year-to-date gains that are now in the neighborhood of 20 percent!

I know of at least two other newsletters that have been recommending rising rate funds for a year or more now and, up until May, that didn’t seem like too bad of an idea. However, over the last four months it has been an unmitigated disaster, in no way even resembling “The Trade of the Decade” as noted here three weeks ago.

From MarketWatch:

Betting against Treasury bonds was supposed to be the no-brainer strategy for 2010. Instead, shorting government debt has brought steep losses so far this year, due to surging bond prices as investors seek safety on worries stocks could be hit by deflationary headwinds.

Clearly, the rest of the world has not yet tired of Washington’s budget deficits and money printing and U.S. debt continues to be the top destination for those seeking safety in these uncertain times. At some point, bond holders will surely balk at getting such a little return on money they lend to the Treasury Department, but that may take a little while longer.

Looking at the debate surrounding this subject may shed some light on when that might be.

Is it Really a “Bubble”? Does it Matter?

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Semantics can be frustrating at times and nowhere else was this more true than for the recently burst “housing bubble” where, for years, pundits debated its existence – that is, right up until the time that home prices plunged. Even the burst housing bubble didn’t meet the “bubble” criteria of some who were looking for price declines in excess of 80 percent or for the value of the underlying asset to be revealed as worthless (think Pets.com).

While much ink has been spilt on the bond “bubble” debate in recent months, in my view, it all seems rather pointless.

Call it what you want – it doesn’t really matter.

The important question is not what you call it, but, whether or not interest rates have (or are about to) reach bottom and if it makes sense to deploy some of your investment capital in order to try to earn a profit from rates going higher.

One of the many arguments that have been made as to why bond prices are “bubbly” come from the data in the graphic below from this story also at MarketWatch.

Clearly, the American public has been attracted to bond funds since the stock market crash in late-2008 and they’ve been downright smitten in recent months, ogling their account balances as they continue to go up and up.

It certainly looks as though investors “piling into” bonds has been a major factor in rising prices and falling yields, yet who’s to say that this trend is about to reverse?

Why should it?

If you’ve listened to Money Magazine in recent decades, you’d have had two-thirds or more of your investment assets in equities of some sort, but, after what has happened in recent years, even the dimmest investors should now realize that this was too much given stocks’ poor risk-reward performance that has only become clear with the benefit of hindsight.

The likelihood that we now have material weakness in the U.S. economy that could get materially worse in the months ahead would argue for investors not opting to take on more risk at this juncture by abandoning the perceived safety of bonds that have treated them so well over the last two years.

Inflation remains quite low in the West with the “specter of de-flation” still lurking and there appears to be no chance that the Federal Reserve will raise interest rates this year with only slightly better odds of the first rate hike coming in 2011. Some now think that the central bank won’t act on interest rates until after the 2012 election and, between now and then, there could be trillions of more dollars spewing from the central bank’s printing press that would be used to buy more Treasury securities.

None of this points to an imminent reversal of the current trend.

In a recent commentary, David Rosenberg of Gluskin-Sheff noted that the typical spread between the 30-year bond and the Fed funds rate is about two percentage points, meaning that, long bond yields could drop by more than 160 basis points from their current 3.7 percent level and the yield on the 10-year note could eventually approach one percent.

While there are certainly good reasons to think that interest rates can’t stay at their current (or lower) levels indefinitely, there is virtually no reason to think that they’ll go substantively higher anytime soon and this is the essence of the debate that should be taking place today rather than to argue over whether the bubble label fits.

Investors should focus on how much lower yields might go and how long that might take.

How Low for How Long?

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Just last week when appearing on CNBC, Dr. Marc Faber, of Gloom, Boom, and Doom newsletter fame, warned investors not to touch 10-year or 30-year bonds and Nassim Taleb, author of “The Black Swan”, recently said he is “betting on the collapse of government bonds” before going on to note that the financial system is riskier today than it was before the 2008 crisis.

Of course, six months ago, Taleb urged “every single human being” to bet against Treasuries, what has clearly been a losing bet to date.

In a Wall Street Journal op-ed($) on Wednesday titled “The Great American Bond Bubble” (alternate link), Jeremy Siegel, author of “Stocks for the Long Run”, warned that if the yield on the 10-year note rises from its current level to a little over three percent, “bondholders will suffer a capital loss equal to the current yield. If rates rise to 4 percent as they did last spring, the capital loss will be more than three times the current yield”.

Never before have the capital gains and losses on bonds been so important and, at this point in the discussion it’s worth making a key point about bonds and bond funds and how they are valued, a point that more investors should understand, but don’t.

If you purchase a bond, you receive regular interest payments (the “coupon”) until the bond matures, at which time you get your principal back regardless of how that particular bond may have traded from the time that you bought it until it matured. Unless you sell the bond before it matures, your only risk is if the borrower defaults.

However, bond funds are a collection of debt instruments that are bought and sold by the fund manager as needed to keep the underlying assets in line with investor demand for shares of the bond fund. As such, the bond fund as a whole never matures, meaning that you can’t ride out falling bond values in a rising interest rate environment in order to recoup your entire original investment.

Unfortunately, this distinction is often overlooked in the recent bond bubble talk, all the more reason to think that, over the short-term, there is little reason to fear that bond prices will plummet and good reason to think that the financial media is simply trying to sell more newspapers, the best example being the WSJ op-ed above.

Over the long-run, however, it is a very different story and there is much to fear for anyone thinking that they can simply hang onto their 401k bond fund and it will provide for them throughout their golden years.

The 30-year downward trend shown above will someday reverse and there is great danger for those people who, as in the dot.com bust and the housing bust, probably don’t see this coming and will, once again, probably get mauled.

Unless we are about to enter a Japan-like lost decade or two where the bond market continues to correctly discount a long period of slow growth and low inflation, at some point, much of the Federal Reserve’s past and future money printing will come home to roost in the form of rising inflation and bond prices could quickly go into a free fall, pushing yields sharply higher.

But, this will not come without a longer-lasting economic recovery.

That’s not to say that the recovery has to be sustainable over the long-run, but, if past is precedent, the odds are good that with sufficient money printing and government spending, the powers-that-be will succeed in lifting the U.S. economy out of the rut it recently re-entered into what looks like a sustainable rebound, much in the same way that the housing boom appeared as though it would last more than a few years.

At this point and for the rest of the year, I’d be more inclined to add bonds to the model portfolio than to bet against them for all the reasons outlined above.

In the end, the question of if and when to bet on rising interest rates depends on the economy and what policy makers in Washington decide to do if, as seems likely now, the economy continues to weaken. If trillions more dollars are summoned in yet another attempt to boost growth and this meets with some success in giving the economy a boost, then fear of inflation will push yields higher (perhaps quickly), a process that had already begun earlier in the year before the recovery faded.

But, unless the Fed announces a new large-scale round of quantitative easing soon, that won’t happen this year. More likely, we’ll see even lower rates in the months ahead with a bottom occurring sometime next year.