How to Protect Yourself from a Bond ETF Bubble | ETF Trends

It’s going to happen sooner or later: interest rates can’t remain at record lows indefinitely. The Federal Reserve at some point is going to have to step in and raise them. If you’re holding bond exchange traded funds (ETFs), you need to understand the risks and how to cope.

The Federal Reserve raised one of its rates last week, alerting millions of investors to the reality that other rates will be raised in the future, as well. Brett Arends for The Wall Street Journal says that such rate increases would be “ominous” for bonds. [What Do Fed Rate Hikes Mean for ETFs?]

Many investors have parked trillions of dollars in bonds, prized for their stability and relative safety, after the events of the last year-plus. That’s trillions of dollars that could get smacked by rate increases. But are bonds in a bubble? [How to Cope with ETF Bubbles.]

Here’s a great chart, courtesy of The Wall Street Journal, that illustrates how bonds work and the impact rate hikes can have on them:

Bond sales are booming. Nearly $400 billion has gone into bond funds since the start of last year. Those sales have pushed prices higher; corporate bonds and Treasuries have gotten increasingly pricey.

Where do you come in? The primary risk lies in inflation, Arends explains. As consumer prices increase, the interest you’re getting from your bonds becomes worth increasingly less. When bond yields are high, this isn’t much of an issue, but right now bond yields are low. Inflation could sock investors once it kicks in. But that’s not all: when inflation kicks in, the government tends to raise short-term rates.

Some people argue that bonds and related ETFs are  a reasonable value, and inflation will stay subdued.

No one is certain about what’s going to happen or when it will happen. The best you can do is to be on your guard and ready to act.

  • wDon’t buy mid- and long-term bonds at their current levels. Long-term bonds will be hit hardest when yields rise.
  • Consider corporate bond funds, which are offering attractive yields right now: SPDR Barclays Capital High Yield (NYSEArca: JNK), iShares iBoxx $ High Yield Corporate Bonds (NYSEArca: HYG) and iShares iBoxx $ Investment Grade Corporate Bond (NYSEArca: LQD).
  • Check out TIPs bond funds. Treasury Inflation-Protected Securities are bonds with built-in inflation protection. Right now, the 20-year TIPS bond promises to pay about 2% a year on top of inflation. iShares Barclays TIPS Bond (NYSEArca: TIP) or iShares Barclays 1-3 Year Treasury Bond (NYSEArca: SHY)
  • Look into dividend ETFs, too. Stocks from solid blue-chip companies are proving to be safer and are on the cheap side right now. Vanguard Utilities ETF (NYSEArca: VPU) yields about 4%.

For more stories about bond ETFs, visit our bond ETF category.

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.