Will the next pop be the bond bubble bursting?

(Money Magazine) -- Question: I'm within five years of retirement and currently have about 35% of my investments in bond funds. With rising interest rates a likely scenario, how do I stay diversified without exposing myself to a "bond bubble"? -- John Clay, East Helena, Montana

Answer: I understand your concern. We've been living in a veritable bubble bath the past 10 years what with two stock bubbles, a real estate bubble and a derivatives bubble. And now, with so much money flooding into Treasury securities and interest rates so low, many people are wondering whether the next pop! we'll hear will be the bursting of a bond bubble.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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But while I certainly believe investors need to be alert to the particular risks of investing in bonds today, I don't think all the hype you hear about a bond bubble just waiting to be pricked is necessarily justified. And I definitely don't recommend that investors avoid bonds because of such "inflated" fears.

For one thing, the idea that we're in a bubble suggests that prices for Treasurys in particular and other fixed-income investments in general are totally out of whack, that they're much higher than fundamentals suggest they ought to be.

But while bond prices are relatively high and interest rates inordinately low, to a large extent that simply reflects the outlook for continued sluggish economic growth and restrained inflation in the near future. Or, as the Federal Reserve Open Market Committee put it in its August 10th statement, "with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time."

Granted, that outlook will eventually change and the Fed's easy-money policy combined budget deficits and all the spending by the guys and dolls down in Washington, D.C., has the potential to reignite inflation at some point down the road. But even if that eventually happens, it could take years for expectations and bond yields to reflect that scenario.

I'm also wary of the phrase "bond bubble" because it conjures up visions of meltdown a la the stock and real estate markets' 50%-plus declines.

But bonds have never had such an Armageddon-like collapse. Indeed, the worst 12-month loss for the U.S. bond market was less than 10%.

What's more, as a recent Vanguard study points out, although the values of bonds and bond funds do take a hit when interest rates rise, investors who own a bond fund or diversified portfolio of bonds will see their returns rise over time assuming they reinvest interest payments in new bonds paying the higher rates.

So what's an investor like you to do?

Ultimately the answer comes down to weighing alternatives. I mean, you could easily avoid a possible bond bubble by selling out of bonds. But then where would you put the proceeds? Stocks?

If anything, I'd say that for someone within five years of retiring, keeping 65% of your portfolio in stocks is probably as far as you want to go, if not already pushing the envelope a bit. Increasing the percentage would leave you at even greater risk than holding onto your bonds since stock downturns are generally far steeper than anything you're likely to experience in bonds.

Some people see safety in gold. But if you mean safety in the sense of stability, it's an illusion. Gold prices jump around like stock prices. If you don't think that's the case, check out some of Kitco's gold price charts.

Of course, you could sell your bond holdings, put the proceeds in cash equivalents like short-term CDs, money-market accounts or money funds and then get back into bonds after the bond bubble bursts (assuming that happens) or the concern about a bubble passes. But in the meantime you would be earning a paltry 1% or less -- and you would have to figure out the right time to get back into the bond market.

Fact is, although it's easy to think that with interest rates so low they have nowhere to go but up, no one really knows what the future path of rates will be, let alone the timing of any movements. Given that uncertainty and the lack of decent alternatives, I think you're better off maintaining your position in bonds while taking reasonable precautions to limit the downside should interest rates rise.

What reasonable precautions am I talking about?

One is making sure the bond stake in your portfolio is well diversified. While Treasury securities offer the most protection from default, they're more sensitive to interest rate changes. So you want to invest in a portfolio that contains both Treasurys to limit credit, or default, risk as well as high-quality corporate bonds that, because of their generally higher coupon rates and loftier yields, won't be hit quite as hard as Treasurys if rates rise.

You also want to stick to the short- to intermediate-end of the maturity spectrum, as bonds with shorter maturities tend to get hammered less in periods of rising rates.

As I've explained before, however, with short-term interest rates so low it's very possible that rates on short-term issues could climb more than those on long-term bonds. Still, over longer periods short- and intermediate-term issues are likely to provide smoother returns and more protection from rising rates.

You could build a portfolio of short- to intermediate-term bonds on your own. Or you could do it much more simply -- and benefit more easily from reinvested interest payments in the event rates rise -- by owning a broadly diversified bond fund that holds both Treasurys and high-quality corporates.

In fact, you can get the entire U.S. taxable bond market in a single fund with a total bond market index fund. That would put you squarely in the intermediate-term range.

If you want to shade your holdings more toward the shorter-end, you could invest some of your money in a short-term bond index fund. Both types are available on our Money 70 list of recommended funds.

For even more diversification, you could devote a portion of your bond money to TIPS, or Treasury Inflation-Protected Securities, and to high-yield bonds. Two caveats, though: Although TIPS give you a guaranteed "real" rate of return above inflation, that real rate has been quite slim lately as investors have been less concerned about inflation.

As for high-yield, or junk, bonds, they're always riskier than investment-grade issues. And they could get hit especially hard if investors become convinced the U.S. economy is headed for a dreaded double-dip recession. So if you do decide to branch out into TIPS and high-yield bonds, think of them as long-term components of a portfolio that you will periodically rebalance.

For more insights into the outlook for the bond market as well as the U.S. economy, I suggest you take a look at my Money colleague Pat Regnier's recent interview with bond guru Bill Gross.

The bottom line, though, is that timing the bond market makes about as much sense as timing the stock market -- i.e., none at all. So despite the cries that the bond market is about to blow, I contend it would be a mistake to pull out of bonds.

A more prudent way to go is to make sure your bond holdings are sufficiently diversified so your portfolio won't be devastated should rates rise, and that it will also be in a position to benefit over time from higher rates.