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By Christine Benz | 09-27-2010 05:53 PM

How Big a Bond Bubble?

While bonds may be a little bit ahead of themselves, the magnitude of potential losses is not as large as the recent stock and real estate bubbles, says Fran Kinniry of Vanguard's Investment Strategy Group.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Investors have been gravitating to bond funds over the past few years, but will that turn out to be a bad bet to have made?

Here to discuss that question is Fran Kinniry. He is principal at Vanguard's Investment Strategy Group.

Fran, thanks for being here.

Fran Kinniry: Thank you, Christine.

Benz: So, let's talk about this bond bubble idea we've seen percolating. Do you think that we're in the midst of a bond bubble currently?

Kinniry: Well, we try to educate on some of the materials we have recently put out. And first I want to define a bubble, the bubble of the stock market typically, you think about a decline of 20%, and same thing even with the real estate bubble that we just saw--significant decline.

So, while we think bonds may be a little bit ahead of themselves and current yields look quite low, a bubble of that magnitude is probably unlikely.

Benz: Okay. So, when you think about the sorts of declines that investors might expect to see in bonds in a sustained period of rising interest rates, can you help put that in context, what might investors expect in the decades ahead?

Kinniry: Sure. I think most people are not used to having a negative return in bonds. And that certainly is a possibility if not a probability at some point in the future when interest rates rise. But if you're broadly diversified and have an intermediate duration, which is a core bond holding, then the order of magnitude of losses have, in the past, come inside of negative 10%, and so something around that should not be ruled out and something even worse. But to think of bubbles that have occurred in other asset classes, we would not expect to see that kind of magnitude of losses.

Benz: Okay. So, one thing I've been hearing from our users is, why not just shorten up? If we are all thinking that rates are going to go up in the next several years, why not just move into short duration securities, bond securities, and call it a day? What do you say about that strategy?

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