ETF Trends featured “How to Protect Yourself from a Bond ETF Bubble.” Here are some excerpts:
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.
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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.
Don’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 (JNK), iShares iBoxx $ High Yield Corporate Bonds (HYG) and iShares iBoxx $ Investment Grade Corporate Bond (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 (TIP) or iShares Barclays 1-3 Year Treasury Bond (SHY)
Vanguard Utilities ETF (VPU) yields about 4%.
I have compared the various ETFs mentioned in the article in the above chart. The red arrow shows that all bond ETFs took a dive during the 2008 massacre, some more so than others.
What it comes down is that it really does not matter which ones you own from the above list, you still need to watch the long-term trend. Yes, that means that there are times when bond funds can be held and there are times when they need to be sold, which translates into the use of a sell stop.
As discussed in a previous post, depending on the volatility of the bond ETF, you can apply the same sell stop as with equities (7%), while for slower moving funds, you could reduce that to 5%.
Look at your risk tolerance and establish an exit plan “now” and not when the market heat is on and interest rates are heading higher.
While I don’t see this happen in the immediate future, you should, nevertheless, be prepared to act.
Disclosure: We have holdings in some of the ETFs discussed above.