With all the uncertainty facing the global economy over the last few years, many investors have turned to bonds - specifically sovereign debt - as a way to get through the madness. Funds like the iShares Barclays 20+ Year Treasury Bond (ARCA:TLT) have surged in popularity as well as assets under management (AUM). The security type's safety and stability hasn't been lost on portfolios, and the rush into IOUs has created some of the best long-term returns out there for investors. This fact has been exacerbated by the Federal Reserve's zero interest rate policies (ZIRP).

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However, no good deed goes unpunished. The steady inflation of bond prices coupled with growing public debts has led many fund managers and analysts to warn that a "bond bubble" has now been created - one that could burst at any moment. For investors - especially those near or in retirement - that popping could lead to dire consequences.

Continuing to Inflate
As investors have sought safety, bond prices have gotten quite a bit frothy, to say the least. It seems that we can't get enough of the asset class. According to The Wall Street Journal, American investors have thrusted more than $220 billion into bond funds this year. In the four years since Lehman Brothers collapsed and kicked off the Great Recession, investors have placed a staggering $900 billion into bond funds. All while withdrawing roughly $410 billion from stocks. It's no wonder why various market pundits have called for the death of equities and it's easy to see why. Over the last three decades, Treasury yields have been in a steady decline, and yields on the 10-year Treasury note are currently trading near record lows. Yet, falling yields mean higher bond prices, and that's created some of the best total returns out of any asset class out there - sans gold.

However, all of this fervor for bonds has created an interesting problem. As investors have kept buying bonds, so has the Federal Government. As Fed Chairman, Ben Bernanke, has pulled out all the stops to reignite the stagnating economy, the central bank has undergone a series of quantitative easing programs. Through its latest program, the Fed has announced that it would begin buying mortgage-backed securities until unemployment falls substantially. Additionally, it said that it would continue to buy up other assets if the economic recovery continues to lose steam. QE 1 through QE 3, along with its Operation Twist, has attempted to push down longer term interest rates. There lies the problem - lower rates come with lower yields. After accounting for inflation, real returns on many bonds are negative.

Those returns will eventually taste sour. So far, the economic recovery has been sluggish, real unemployment continues to be disturbingly high and inflation is relatively low. However, when the recovery happens, inflation rises or bond investors wake-up and demand higher interest rates from the U.S. Due to its historically large and growing debt burden, the so-called bond bubble will pop. This will send prices for existing IOUs crashing and leave many investors holding the bag.

When and What to Do About It
The tricky part in all of this is picking just when the next bubble will pop. Plenty of market pundits have been calling for the "popping" for quite some time. Even Bond King Bill Gross, in his PIMCO Total Return Fund (ARCA:BOND) notably missed a surge in Treasury prices as he admitted he was ahead of the curve. Unfortunately, by the time things get really ugly it might be too late for most investors. However, there are some things investors can do to prepare. The obvious one is to hedge ones bond holdings and bet against the treasury market. The ProShares Short 20+ Year Treasury (ARCA:TBF) allows investors to short long-term treasury bonds, while the Direxion Daily 20+ Yr Treasury Bear 3X (ARCA:TMV) provides a leveraged short position. Keep in mind that these may be a losing proposition for quite a while until the bubble pops.

Secondly, reducing the exposure of a portfolio to bonds and finding other income solutions will also be key. Senior-rate bank loans adjust rates every 30 to 90 days, making them quite attractive in rising rate environments. The PowerShares Senior Loan Portfolio (ARCA:BKLN) allows investors to bet on a basket of these securities and yields about 5%. Finally, when the bond bubble pops, stocks will undoubtedly become the asset du-jour once more. A prudent bet could be on a dividend-focused fund like the Vanguard Dividend Appreciation ETF (ARCA:VIG).

The Bottom Line
While most investors have flocked to bonds looking for safety, trouble is brewing for the asset class. As interest rates eventually rise, the popularity of IOUs will eventually be its downfall. This popping of the bond bubble could have serious consequences for investors who aren't prepared, but it may open up serious opportunities to make money for those who are.

At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.

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