Shaken by the financial debacle of 2008, jumpy investors turned to bonds and related exchange traded funds (ETFs) to safeguard what was left of their wealth. The problem with this scenario is that investors aren’t letting go of bonds, despite the changing investment atmosphere.

The Federal Reserve opted to leave interest rates unchanged for now, so the risk is low at this point. But as the economic recovery continues along, the risk that rates will rise is a very real one and if you’re holding bonds, you need to understand the impact that this will have.

Even after a rally going in stocks, investors are still clutching firmly to bond funds, writes Eileen Ambrose for The Baltimore Sun. Most market experts expect interest rates to start going up in the second half when the economy shows more signs of recovery, and the outcome won’t be favorable for bond holders. [How to spot and avoid ETF bubbles.]

Between January and November last year, net inflows into bonds hit $349 billion, $27 billion more than in 2008, while stocks saw outflows of $4.1 billion in the first 11 months on top of the $234 billion outflow from stocks the year before. [Bond ETFs: Good times coming to an end?]

People are still investing in bonds because of reasons like retirement, dramatizing effect of 2008 on investors and the higher yields offered as compared to money market funds. John Rekenthaler, vice president of research at Morningstar, says that high-quality bond funds such as long-term U.S. Treasuries will be most vulnerable when rates go up. High-yield funds we be least affected if rates rise in an improving economy because it is believed that companies are less likely to default in a healthy economy. [It’s time to look at bonds differently.]

  • iShares Barclays 7-10 Year Treasury Fund (NYSEArca: IEI)
  • iShares iBoxx $ High Yield Corporate Bond (NYSEArca: HYG)
  • SPDR Barclays Capital High Yield Junk (NYSEArca:JNK)

Portfolios still need some bonds for stability in the long-term. Investors may want to rearrange their holdings and stick to bonds with short-term maturities. Rekenthaler also suggests investing in funds with foreign bonds because “other countries’ interest rates might not rise and sink with ours.” Investors may also consider dividend-paying stocks or municipals as alternatives.

  • iShares Barclays 1-3 Year Treasury Bond (NYSEArca: SHY)
  • PIMCO 1-3 Year U.S. Treasury Index Fund (NYSEArca: TUZ)
  • SPDR Barclay International Treasury Bond Fund (NYSEArca: BWX)
  • SPDR Barclays Short Term International Treasury Fund (NYSEArca: BWZ)
  • iShares S&P National Municipal Bond (NYSEArca: MUB)
  • PIMCO Enhanced Short Maturity Strategy Fund (NYSEArca: MINT)
  • Market Vectors Short Municipal (NYSEArca: SMB)
  • SPDR Barclays Capital Short-Term Muni Bond (NYSEArca: SHM)

It is easy to get caught inside of a bubble and then miss warning signs that are telling you to get out. This is why we have an 8% stop loss – once a fund declines 8% off the recent high or dips below its 200-day moving average, we get out. Having a strategy with a stop-loss can help put a limit on your overall losses. [ETF trend following strategy.]

For more information about ETF strategies, check out The ETF Trend Following Playbook.

For more information on trend following, visit our trend following category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.