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Tuesday, March 26, 2013 - 13:00
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Tuesday, March 26, 2013 - 13:00

A Bubble Bigger than Housing Is About to Pop -- Here's How to Protect Your Portfolio

Tuesday, March 26, 2013 - 1:00pm

The most devastating market events are those that no one sees coming.

Take what happened to the Lehman Brothers in 2008, for example. Up until the last minute, virtually no one could have imagined one of the country's leading investment banks would file for bankruptcy. The housing market crash was the same way. The Street believed housing prices would never go down.

With the market totally blind to the growing risk in each investment, anyone who had investments in housing or with Lehman Brothers suffered huge losses.

Despite these tough lessons, there is now another epic bubble developing and the market is ignoring this one too.

In fact, this bubble is so big, the 2006 housing bubble and the 2000 bubble pale in comparison. And when it pops, it will hit the most conservative portfolios the hardest.

While investors were burned by big losses in 2008, risk-averse investors have been flocking into the safety of Treasury bonds. In just the past four years, investments into bond mutual funds have doubled to $4 trillion. But this perceived bastion of safety is more like a ticking time bomb waiting to explode. And when it does, it will devastate any portfolio with a heavy allocation to Treasury bonds.

Here are four reasons why it's time to sell treasuries.

1. Risk and reward
The best reason to abandon the bond market is a simple matter of risk and reward.

With the U.S. Federal Reserve beating yields into the ground in the past four years, the risk-reward ratio in the Treasury market is terrible. If the yield on the 10-year Treasury note fell to zero from its current 1.9%, then bond prices would rise about 17%, according to Timely Portfolios. On the other hand, if the yield grew 2-3%, bond prices would fall about 20%.

In 1994, at the beginning of the epic stock market rally, bond yields jumped 240 basis points in nine months. If that were to happen again, bond prices would plunge 50% and anyone holding Treasury notes would sustain huge losses.

2. Yields have never been lower
According to O'Shaughnessy Asset Management, 2013 could be the most difficult environment in 140 years to generate income. That's because it's the most affordable time in 223 years for the U.S. government to borrow on a 30-year term. In relation to the risk/reward proposition, yields on Treasuries really have only one way to go, and that is up. And when they do, it will have dire consequences for bond investors who think they are making "conservative" investments.

3. Too much debt
Adding fuel to the debate about Treasury yields is the fact that the United States has rarely, if ever, been in a worse financial condition.

On a consumer level, a weak financial profile means higher borrowing costs. But with the Fed working its magic over the market and artificially pounding yields into the ground, the bond market no longer reflects the financial condition of the United States. For the time being, the country continues to get a free pass from the world and the bond vigilantes for its wild spending and unsustainable fiscal deficits, but a correction is sure to happen. And when the United States is forced to pay higher borrowing costs due to its unsustainable deficits and ballooning debt, the bond market and its investors will suffer huge losses.

4. The private sector
Although the economy is plagued by high levels of unemployment and slow gross domestic product growth, the private sector has rarely been stronger. Earnings, margins and cash balances are at an all-time high, which makes equities and corporate bonds attractive alternatives to Treasuries carrying huge credit and interest-rate risk.

Risks to Consider: There is a classic saying on the Street: "Don't fight the Fed." The Fed is the single most powerful financial institution in the world and remains fully committed to keeping rates down. Although the United States is in horrible financial condition, the market still views Treasury bonds as a safe haven, which could send prices higher if another financial crisis hits the Street.

Action to Take -->
Despite the country's battered financial condition, Treasury bonds are still viewed as one of the safest securities in the world. But with a terrible risk-reward ratio, growing fiscal deficits, record-low yields and attractive alternatives, the Treasury market is ripe for a long overdue correction. That's why it is time for forward-thinking investors to sell their Treasury bonds and protect their portfolios from huge losses.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.