Don't Fear This Market Bubble

It's hard to wrap my mind around the idea of a "bond market bubble." To me, it sounds like something like a drag race between powder-blue Cadillacs -- you know, the kind with white vinyl roofs and plush velour seats. It's just not the kind of excitement one expects to find in a corner of the market many of us think of as, well, sedate.

But thanks to a prolonged period of low interest rates, bond prices have gotten awfully high -- and that sets off bubbly alarm bells for some. Those of us who have been investing long enough to remember the late 1990s (or who have paid attention to the lessons of history) tend to get uneasy when we see signs of an overheated market for just about anything.

After all, one round of watching a company like Amazon.com go from more than $100 to under $6, or Akamai (Nasdaq: AKAM  ) go from more than $300 a share to under a dollar, as they did between 1999 and 2002, should be enough to impart a lasting lesson: Careful investors avoid market bubbles.

But sometimes investing in a bubble market is actually the right thing to do -- or at least, not as bad as you might think. Even for careful investors. Maybe even especially for careful investors.

A bubble we can believe in
The story behind the bond bubble is a pretty simple one. Bonds, of course, tend to rise in price as interest rates fall, as investors become more willing to pay a premium for yield. And with interest rates near historic low levels until recently, those premiums got quite, well, bubblicious, at least to a casual observer.

That in turn means that folks looking to buy bonds are looking at high prices that are likely to decline as interest rates rise, something that has already started happening in recent months. At one point last month, the Vanguard Total Bond Market Index ETF (NYSE: BND  ) had fallen from almost $83 last November to below $79, a move of almost 5%, before recovering somewhat in recent weeks. That's big stuff in the bond world, and some say that's just the beginning: Interest rates are still pretty low and could be rising for a long time.

That's enough to make careful investors think twice about bonds, and I suspect that means that many investors who should be putting a portion of their portfolios into bonds are holding stocks instead. That's not good. But here's the thing: If you had bought Akamai when it was under a dollar -- or to choose a less dramatic example, a maybe-value-priced large-cap stock like General Motors (NYSE: GM  ) today -- you'd have done so because you were hoping for price appreciation, first and foremost. You'd be betting that Akamai would survive and thrive, as it has, or that GM will reclaim its former market-leading position in worldwide production, which it might. That's the reason we buy most stocks.

But as my favorite retirement guru recently pointed out, that's not why we buy bonds. At least, not exactly.

Price isn't as important as you think
Robert Brokamp, the aforementioned guru, is lead advisor of the Fool's Rule Your Retirement service and someone who pays a lot of attention to the ins and outs of retirement investing. In the new issue of Rule Your Retirement, available online at 4 p.m. ET today, he writes at length about why the bond bubble shouldn't scare investors away from bonds altogether.

As Robert notes, we buy bonds and bond funds for income, not capital appreciation. Sure, we don't want to lose capital, but mostly we want that nice steady interest stream. And over time, if we reinvest it, that interest stream will provide plenty of appreciation even if interest rates aren't going in our favor. And with a bond fund, over time, the underlying bonds will be replaced by new bonds paying higher rates of interest.

Of course, how well this works depends on the exposure you choose. Bonds with longer terms tend to have higher yields, but their prices tend to be more volatile in the near term. Bond funds use a measure called duration to indicate their sensitivity to interest rate changes. A longer-term bond fund like Vanguard Long-Term Bond Index ETF (NYSE: BLV  ) has a much longer duration than its short-term counterpart Vanguard Short-Term Bond Index ETF (NYSE: BSV  ) , which makes it more volatile, but on the other hand, the long-term ETF's yield is 5% to the short-term fund's 2.2%. Greater risk, in other words, could yield greater rewards.

Still not sure about all this? Take a look at Robert's full analysis and run the numbers with him in the new issue of Rule Your Retirement. Rule Your Retirement is a paid service, but you can get full access for 30 days absolutely free with no obligation to purchase -- just click here to get started.