With stocks now in record territory it’s a good time for investors to look to diversify into other asset classes. Bonds are a natural diversification away from stocks, but are bonds one of the good investment choices for 2013? And after decades of strong bond performance, could we even be on the edge of a bond bubble?

It all hinges on interest rates . Since bonds move in an inverse direction to interest rates – when rates rise, bond prices fall, and when interest rates fall, bond prices rise – the fate of bonds rests entirely upon the direction of rates.

The Case for Bonds in 2013

Bonds can prove to be a solid investment this year under at least four different scenarios.

1. Interest rates could stay low for several more years.

Though the economy is growing, it is doing so at a relatively slow rate. There is little incentive for the Federal Reserve to advocate for higher interest rates at this point, and that can mean several more years of low rates. That being the case, 30-year US Treasury bonds paying in excess of 3% per year are a whole lot better than short-term savings instruments that are paying well below 1%.

2. Interest rates could go even lower, raising bond prices.

Though interest rates are at historic lows, that doesn’t mean that they cant go even lower. The economy is growing slow enough that it could drop into negative territory, and if it does, there will be tremendous pressure to lower interest rates even further. Should rates drop, not only will a 3% 30-year bond rate be highly desirable, but the price of those bonds can also increase as a result, leaving the holder of the bond with a substantial capital gain – in addition to the higher than market rate.

3. Bonds could be safer than stocks in a market fall.

It’s possible that the stock market could decline even though the overall economy stays in a modest growth phase and interest rates remain level. From a standpoint of safety of principal, bonds could become the preferred investment of 2013 as a place to earn relatively high interest rates without any risk of principal.

4. International instability.

Still another development that could prove to be an advantage for bonds could be international instability causing a flight to the safety of US investments in general, and of bonds in particular. Such a development could cause interest rates in the US to decline (and bond prices to rise) as a result of a flood of foreign money looking for safe haven investments. Bonds would be a natural destination for that capital, turning 2013 into one of the best-performing years ever for the asset class.

The Case for a Bond Bubble Burst in 2013

All of the above outcomes notwithstanding, it’s hard to argue in favor of bonds given that they are at such extreme levels. Logic – and the law of changing circumstances – almost dictate that a shift (a bond bubble) is coming. Will it happen in 2013? And if it does, what are some possible scenarios?

1. Bonds can’t compete with returns on stocks.

Let’s say that interest rates don’t rise in 2013 – that should make bonds a solid investment for the rest of the year, shouldn’t it? Maybe not. If stocks turn in another strong year – and let’s say that they earn 10% for the year – you will lose about 7% on your money for every dollar invested in bonds and not in stocks. Stocks and bonds compete with one another, and with interest rates as low as they are it isn’t hard for stocks to win the competition. This could lead to a gradual exodus out of bonds and into stocks, forcing interest rates higher and accelerating the problem.

2. Historic low rates are bad for bonds.

Interest rates on bonds are at historic lows, and that should always make an argument in favor of caution. It’s also the strongest argument in favor of a bond bubble. Sooner or later, rates will turn up and then.

3. Interest rates could rise, crushing bond prices.

The nuclear scenario for bonds would be a reversal of an over 30-year trend of steadily declining interest rates. Should the market begin demanding 4% or 5% on long bonds, the bond market in general will take a bath. This can tie your money up in a very long-term security that could leave you holding an investment with sub-par interest rates and no way to get out without losing money.

4. 30-year bonds aren’t much different from stocks.

In rising interest rate market environments, bonds can prove to be no safer than stocks. While it’s true that you will recover your entire principal balance if the bond is held to maturity, the market value of that bond can fall substantially before that happens. If you are in year number three of a 30-year bond, the security can behave very much like a stock and fluctuate wildly. The story of low interest rates make this more than a remote possibility for bonds in 2013.

What are your thoughts on bonds as an investment in 2013? Good investment, bad investment – or even the beginning of the long awaited bond bubble collapse? Leave a comment!