It depends. In the usual development setup they are installed where they would be when you install a gem "normally" (by running gem install foo) and bundler won't reinstall gems that are already there. This location depends on how rubygems itself is configured.
If you run bundle install with the --deployment option then the gems will be installed in a location unique to your app (you can pass this as a separate option but it defaults to vendor/bundle)
You can also run bundle package to store all the .gem files your app uses in vendor/cache. Running bundle install will prefer gems in vendor/cache to gems in other locations.
Note that gems are also installed into the bundle folder within your "Gem Path" (see: bundle env). This happens, for example, with gems installed from git:
gem 'my-gem', git: "https://github.com/x/y.git"
I assume this is so that custom installations don't conflict with installations from a gem server.