Long-term government bonds outperformed stocks over the past 20 years ending in 2011, but the next 20 years may be a very different story.

The Fed’s move to hold down long-term interest rates has driven investors elsewhere to look for yield over the past few years. With 10-year treasuries yielding approximately 1.8%, investors plowed jaw-dropping sums in 2012 into corporate bonds and junk bonds hoping to find higher yields.

However, while investors have been piling into bonds in search of a safe yield, they may be sowing the seeds of their own destruction.

In addition to the Fed’s actions, investor appetite for bonds has driven high yield and investment grade corporate bond yields so low there is little room for them to go much lower (and therefore increase future returns).

When the taste for bonds begins to subside and/or the Fed allows rates to begin creeping upward, bond-holders will face losses. Like a see-saw, when interest rates rise, bond values fall.

For investors who swore-off stocks and piled into bonds after the recent meltdown, bonds may prove a major disappointment. To demonstrate how razor-thin the margins are –a 10-year treasury note with a 1.7% yield today would drop 9% in value with a mere 1% rise in rates according to the Vanguard Group.

In response to the potential bond bubble, we are modifying our bond investments to lower the effective duration (In English: We are buying more short-term bonds). And we are moving out of bonds we believe pose greater risk of default such as Japanese government bonds. We are also increasing portfolio allocations to natural resources, which may help to hedge against falling bond values –especially in an inflationary environment.

Bubble photo by Rhett Maxwell used under Flickr Creative Commons License.