There have been a slew of articles already in 2013 warning investors who have piled into fixed-income funds about the dangers of rising interest rates. Yet there are steps ETF investors can take to protect themselves from higher yields and lower bond prices.

For example, some experts are advising fixed-income investors to take shelter in high-yield bonds, bank loans and emerging market debt.

“Wall Street is in the process of turning one of its most plain vanilla investments – and one that average investors have flocked to in recent years because of its perceived safety – into ticking time bombs,” Fortune said in a recent story on bond funds. “Many market gurus say that this may finally be the year that interest rates, which have been at historic lows, march up.”

Bond prices and rates move in opposite directions.

‘Train wreck’

“We’re going to have a bond bear-market, like the bear market in stocks. This will be the most predicted train wreck in history,” Art Steinmetz, chief investment officer at OppenheimerFunds, tells MarketWatch.

But the timing of this reversal is not predictable. That’s one reason why Steinmetz is not an outright bond bear, according to the report. He’s still comfortable with credit risk, but is being extremely selective about the types of bonds he’d keep in a portfolio. [Will the Bond ETF Bubble Burst in 2013?]

“People are loaded to the gills with super-safe investments and they’re not recognizing that the definition of ‘super-safe’ has changed,” Steinmetz said in the MarketWatch story.

He recommended investors look to bond sectors that have some cushion or pay high yield.

One area is junk bond ETFs such as iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK).

“The Fed is on hold and company balance sheets are in good shape with respect to positioning and timing of debt,” Steinmetz noted. “Companies are sitting on a lot of cash and they’ve boosted productivity. That’s great if you’re a bond investor because the likelihood the company can pay you back grows.”

“Yields have been pushed down by a highly aggressive central bank policy, with the result that yield-oriented investors have been pushed into owning lower-rated credits. As a result, the yields on riskier debt are as low as they have ever been,” adds Fran Rodilosso, fixed income portfolio manager at Market Vectors ETFs. “But the credit spreads, the difference between the yield on a high yield bond and a Treasury security, are actually closer to their historic average.” [Are High-Yield Bond ETFs Overvalued After Big Run?]

Senior loans and emerging markets

Also, senior bank loan ETFs such as PowerShares Senior Loan Portfolio (NYSEArca: BKLN) and Pyxis iBoxx Senior Loan (NYSEArca: SNLN) are paying decent yields and provide some protection from rising interest rates.

“Most investors typically become interested in bank loans when interest rates are expected to rise,” says Morningstar analyst Timothy Strauts. “With the Federal Reserve committed to maintaining low rates for the next several years, current investor apathy to bank loans shouldn’t come as a surprise. But with yields in the high-yield-bond sector near historic lows, bank-loan funds are looking more and more attractive on a relative basis.” [Senior Bank Loan ETFs Yielding 5%]

Finally, Steinmetz at OppenheimerFunds encouraged investors to look to emerging market bonds for yield. Developing countries are in better financial shape, cutting their relative risk, he told MarketWatch.

ETFs for emerging market debt include iShares JPMorgan USD Emerging Markets Bond Fund (NYSEArca: EMB), PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY), WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD), Market Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC), SPDR Barclays Capital Emerging Markets Local Bond ETF (NYSEArca: EBND). Some of these products hedge their foreign-currency exposure, while others do not. [Why Emerging Market Bond ETFs Could Stay Hot in 2013]

Bond investors can also protect themselves from rising interest rates by moving into funds with shorter durations. Of course, yields here are extremely low, but these ETFs won’t feel the bite of rising rates as much. Short-duration ETFs include PIMCO Enhanced Short Maturity Strategy (NYSEArca: MINT), SPDR Barclays 1-3 Month T-Bill (NYSEArca: BIL), iShares Barclays Short Treasury Bond (NYSEArca: SHV) and Guggenheim Enhanced Short Duration Bond (NYSEArca: GSY).

Full disclosure: Tom Lydon’s clients own HYG, JNK, EMB.

The opinions and forecasts expressed herein are solely those of John Spence, 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.

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