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I've been watching the market for U.S. government bonds with a wary eye for a while now, and I'm certainly not the only one. In his annual letter to Berkshire Hathaway (NYSE: BRK-A ) shareholders earlier this year, Warren Buffett called out bloated bond prices and said the eventual correction could rival the Internet bubble earlier this decade.
Why would he make such a bold statement? A quick look at bonds over the past 40 or so years shows that the yield on 10-year Treasuries peaked in the mid-teens back in the early 1980s and has steadily fallen since then, to get us to the 3.9% yield we're currently experiencing.
Just as stock investors get burned when they pay too high a price for a stock in relation to its profits, bondholders put themselves at risk when they accept a yield that's too low -- particularly when the issuing government is printing money like it's a new parlor game.
For a while, I was regarding the bond market as a bomb that was about to go off in a contained area -- similar to the way people were talking about subprime mortgages in the early days of the credit crisis. More recently, it's been hitting me like a Chuck Norris roundhouse kick that my previous viewpoint was just silly.
The credit market problem
If the bond bubble meets an unfriendly needle, investors will push down the prices of Treasuries. When those prices fall, the yields will rise. When the yields on the secondary market rise, new issues will have to be priced with higher yields to get them sold. Higher-yielding new issues could start a negative feedback loop that will spook bond investors further.
I'm no bond expert, but I do know from listening to bond-smart folks that, unlike Las Vegas, what happens in the Treasury market doesn't always stay in the Treasury market.
Rising Treasury yields will feed into other parts of the bond market and push up yields on things like corporate debt and mortgages. Jumping mortgage rates would put a major damper on any nascent stabilization in the housing market, just as higher corporate rates would make things even more difficult for debt-laden companies like Sirius XM and MGM Mirage (NYSE: MGM ) .
And of course it would get much more difficult for the U.S. government to continue trying to hoist the economy out of the muck if it finds itself suddenly having to finance massive deficits with increasingly pricey debt.
The stock market problem
Unfortunately, the stock market probably won't get to whistle past the graveyard if the bond market starts tumbling. As I noted above, there are problems aplenty created by a struggling bond market, and these will likely impact everything from general economic conditions to corporate profits to stock market sentiment.
All in all, it doesn't quite sound like a recipe for stock market success. Remember that in the 1960s and '70s, bond yields rose rapidly -- starting at a level similar to what we see today -- and, at the same time, the stock market largely stagnated. With an already fragile economy, it'd be tough to expect stocks to hold up much better this time around.
In fact, over the past few days, we've seen exactly how bond market events can impact the stock market. The market's loss on Wednesday was largely attributed to a weaker-than-expected demand for an auction of 10-year Treasury notes, while the rebound on Thursday was driven by strong demand during the sale of 30-year Treasuries. Want to guess what the impact might be if we had an extended slump in the bond market?
A prepared portfolio
All that said, I'm not draining my portfolio of stocks and running for the hills. Instead, I'm starting to eye stocks that will weather a bond-market storm well.
What do these potential survivors look like? Well, I'd include the traditional "defensive" stocks such as Johnson & Johnson (NYSE: JNJ ) and Procter & Gamble (NYSE: PG ) in the group. Quality companies that have little or no reliance on debt -- companies like Stryker (NYSE: SYK ) and ABB -- would also be good picks.
And since rising bond yields and inflation usually party together, exposure to commodities could help stabilize your portfolio as well. I'm not much of a fan of gold (though other Fools are), but ever-useful commodities like oil and fertilizer have piqued my interest. There are a heck of a lot of stocks that can get you exposure to commodities, but big boys like ExxonMobil (NYSE: XOM ) and Chevron are easy ways to hitch your buggy to oil, while Mosaic (NYSE: MOS ) is one of the key companies in the fertilizer market.
There's no reason that these "bond disaster preparedness" stocks have to take over your entire portfolio, but they can sure be a nice defensive complement to riskier or more pro-cyclical picks.
Is the best offense a good defense? We may soon find out.