Bubble trouble for bonds?

(Fortune) -- Andrew Mellon, the banking icon, once famously said: "Gentleman prefer bonds." The implication being that bonds, while less perhaps less sultry than equities, will generate a predictable return for investors, and not put their investments at serious risk of capital impairment. Ostensibly the latter part is true: bonds sit higher up in the capital structure of and therefore have more downside protection. If a company performs poorly and its stock goes down, stockholders get nothing. On the other hand, if a company can't pay off bonds it's issued, investors could end up at least owning the company and its assets.

Asset allocation decisions are made based on many factors. The correct allocation with the appropriate timing can ensure both capital preservation and capital growth for investors. In the construction of a diversified portfolio, a critical decision relates to the appropriate percentage of allocation to bonds versus equities versus other asset classes.

Investors have effectively three choices as it relates to bond, or fixed income, allocation: government bonds (at all levels of government), investment grade bonds, and junk bonds. In theory, the credit worthiness occurs in that order as well, and yields go down as credit worthiness goes up. So government bonds will have lower yields than similar duration corporate bonds, and vice versa.

A river of money is flowing into bonds

According to the Investment Company Institute, investors have poured almost $400 billion into bond funds since the start of 2009 and in aggregate there is more than $2.2 trillion invested in bond funds. As a result of this massive inflow of money into bond funds and the government's purchase of government bonds as part of its quantitative easing program, yields in the bond market have come down substantially since the credit crisis of late 2008. So, given the massive inflow into bond funds over the past, the question remains: Are we in a bond bubble?

The answer is nuanced. From a longer term perspective, bonds are, broadly speaking, at near all-time lows in yield. In particular, given the current loose monetary policy being implemented by the Federal Reserve, Treasury bonds are at close to all time lows in yield, and therefore highs in price. Given this extreme in Treasury bond pricing, there is clearly bubble potential in the U.S. government bond market.

A quick Google search of "Bond Bubble" indicates that pundits have been suggesting bonds are in a bubble very consistently for the past three years. While it is easy to make a call that an asset class is in a bubble, it is more difficult to be accountable to the timing of such a call. In addition, a bubble inherently implies that the unwinding of that bubble will be a crash. So far the pundits have been wrong both counts.

We've charted the spread of corporate junk bonds bond versus 5-year treasuries and corporate investment grade bonds versus 5-year treasuries going back to 2002 (see chart above). Interestingly, while yields for both investment grades and junk bonds are close to their lows in yield for this period, currently at 8.24% versus their low of 7.75% for junk bonds and 4.7% versus their all time low of 4.5% for investment grades, the spreads between 5-year treasuries remains relatively wide. In fact, these spreads bottomed in 2007 at 0.93% for investment grade and 3.1% for junk, versus their current spreads of 2.30% and 5.74%, respectively.

Bonds don't exist in a vacuum. So is there a Treasury bubble?

Since the price of bonds should never be taken in isolation, if there is a bubble in bonds, it is likely related to Treasuries. The case for the Treasury bubble is effectively three-fold:

First, as mentioned, they are being priced based on extreme monetary policy that will not be sustained in perpetuity.

Second, they are incorporating very limited expectations for inflation, which we believe will occur and perhaps in dramatic fashion.

Third and finally, government bonds will eventually have to reflect the declining credit worthiness of the Unites State based on the United States' deficit as a percentage of GDP and growing debt to GDP ratios.

Treasury bonds cannot stay at their current yield level forever. And while we have seen some correction, yields and prices for U.S. government bonds are still at generational extremes. In reality, though, just as it took decades for interest rates to come down from the meteoric highs of the 1980s, it will take interest rates time to go up, and it is likely that no crash is imminent. So even if there is a bubble, there won't likely be a "pop." This move will be long and sustained.

From an investment perspective, the most effective way to play the re-pricing of Treasuries over time is to be short Treasuries out right, or to play a narrowing of the spread between treasuries and corporate bonds.

The reality is, gentleman -- and ladies -- do prefer bonds. But, only when the price is right.

--Daryl G. Jones is Managing Director of Hedgeye.