Jamie Dimon Warns of Inevitable "Crack" in Bond Market. What Investors Need to Know

I've a confession to make: I love the term "bond vigilantes."

Admittedly, it's a bit esoteric -- not something that comes up in everyday conversation. Derived from the Latin vigilare, meaning "to keep awake," Merriam-Webster defines a vigilante as "a member of a volunteer committee organized to suppress and punish crime summarily (as when the processes of law are viewed as inadequate)." In the world of finance, a bond vigilante is someone (or a group of someones) who prevents government from taking on more debt than it reasonably should, by demanding higher and higher interest rates in exchange for buying increasingly shaky Treasury bonds.

As interest rates skyrocket, and it becomes more expensive for the government to sell its T-bills, the government is effectively forced to rein in its debt spending and act more responsibly -- like it or not.

And why do I bring this up in the first place?

Because according to Jamie Dimon, the well-respected CEO of megabank JPMorgan Chase (NYSE: JPM), the bond vigilantes are back. And they're almost certain to force the U.S. government to cut spending (and borrowing) sooner rather than later.

Image source: Getty Images.

What Jamie Dimon said

Speaking at the Reagan National Economic Forum in Simi Valley, California, on the subject of recent rises in the cost of selling government bonds, Dimon was asked point-blank if bond vigilantes are back. He responded simply, "Yeah."

Dimon takes the government to task for "massively over[doing] both spending and [quantitative easing]" to support the economy during shutdowns. "We borrowed and spent $10 trillion from 2020 to today," Dimon said. He continued, "I don't really know the full effect of that."

But one thing is certain:

You are going to see a crack in the bond market. Okay? It is going to happen [and] you're going to panic.

What a bond market crack means for JPMorgan -- and for you

Dimon doesn't spell out exactly what he means by "a crack in the bond market," but it's not too hard to figure out. If bond investors (the aforesaid vigilantes) get worried that the government even might not be able to repay its debts, they are going to demand additional compensation for taking on this risk. Specifically, they'll require higher and higher interest rates before they agree to buy government debt.

Each incremental high-yielding bond adds to the national debt, of course, and to federal interest payments, which in turn makes it even harder for the government to repay its obligations. Lather, rinse, and repeat, and the situation only gets worse from here.

Pretty soon, the government simply cannot sell more debt -- and the bond vigilantes will have won.

This crack in the bond market will be "terrible for the banking industry," warns Dimon, (with the exception of JPMorgan, which is anticipating the bond market collapsing, and which Dimon says will therefore make money when the crack happens). It'll be terrible for anyone holding old bonds, too, because as new bonds are issued at higher and higher interest rates, no one will want to hold the old, lower-paying bonds, and their prices will fall.

Dimon seems 100% convinced of this fact, and is only uncertain on timing: "I just don't know if it's going to be a crisis in six months of six years," the JPMorgan CEO said.

What should an investor do now?

So how should an investor today plan for the bond market "crack" that Dimon says is inevitable? First and foremost, I certainly wouldn't recommend buying any long-dated U.S. Treasury securities. Short-term Treasuries, say, those maturing in three months or less, should be one way to limit risk.

I'd also be leery of investing in companies carrying excessive debt loads. As the bond market cracks, and interest rates move higher, these companies will need to compete with the government and the high interest it is offering for debt, when seeking to refinance their own debts. This will raise their interest costs and eat into their profits (assuming they're even profitable).

It's much better to invest in stocks with fortress balance sheets that won't need to take on debt when the bond market cracks -- and can opportunistically swoop in to buy weaker, debt-laden companies. For that matter, you might want to start stockpiling a little extra cash of your own, so that when the bond market does crack, and the stock market crashes, you'll be in a position to pick up some bargains yourself.

Because a bond market crack is coming.

And Jamie Dimon is staking his reputation on it.

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JPMorgan Chase is an advertising partner of Motley Fool Money. Rich Smith has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase. The Motley Fool has a disclosure policy.