What to Do as Bonds Crack

The collapse of the bond bull has been long prophesied, and now it's finally here. However, investors don't need to, and shouldn't, pile out of fixed income entirely; they just need to change strategies, writes MoneyShow's Howard R. Gold.

If you've kept your ears open, you may have heard a huge rumbling, like the earth shaking or a redwood falling in the forest.

It wasn't a natural disaster, but the sound of the bond market cracking, heralding the long-awaited correction—or end—of a three-decade-long bull market.

Many have predicted it, and they have been either "early" or wrong. But this time there are signs it's for real:

• Federal Reserve chairman Ben Bernanke hinted Wednesday the Fed may start unwinding its extraordinary bond buying program later this year, causing stock and bond prices to plunge.
• Some of the hottest, riskiest sectors of the bond market have sold off big lately.
• Investors who have poured money into bond funds for years are now bailing out in earnest.

The sell-off in risky assets is the most telling. Last September, I named long US Treasuries, Treasury Inflation Protected Securities, and high-yield bonds as the market's three most overvalued assets. I could easily have added emerging-market bonds to that list.

Read Howard's commentary for MoneyShow.com on the three most overvalued asset classes.

All have tumbled dramatically from their highs:

• The iShares Barclays 20+ Year Treasury Bond (TLT) has lost 15% of its value since its July 2012 all-time high.
• The iShares iBoxx $ High Yield Corporate Bond (HYG) has declined nearly 5% from its recent high.
• The iShares Barclays TIPS Bond (TIP) has slid 8.6% from its all-time high in December.
• The iShares JPMorgan US Dollar Emerging Markets Bond (EMB) dropped 11.2% from its all-time high last October to its recent low in June.

Other beneficiaries of the yield mania-real estate investment trusts, master limited partnerships, mortgage REITs, and business development corporations—all have had their clocks cleaned.

Whether this is really the long-awaited end of the bond bull remains to be seen. But investors are acting as if it is, creating a self-fulfilling prophecy.

"Everybody's trying to preempt the Fed" by selling early, said bond maven Marilyn Cohen, CEO of Envision Capital Management in Los Angeles. "It's all part of the psychology that the Fed is going to do its evil deed sooner or later."

Last week, investors yanked a record $14.45 billion out of bond funds, EPFR Global reported, topping the previous record $12.53 billion in net outflows set the previous week. High-yield and emerging-market bond funds suffered their second-biggest weekly withdrawals on record. This follows five years in which investors poured more than $1 trillion into bond funds.

NEXT: What to Do Now

"People knew it was going to happen, and then when it happens, they freak out," Cohen told me in an interview. She expects bond yields to move up over a long period.

If stocks have a 10% to 12% correction, said Cohen, yields on the ten-year Treasury note could fall from Wednesday's high above 2.3%. But they won't hit 1.379% again, as they did last July. "I think we've seen the lows," she said.

The good news: You still have time to prepare. The key to mitigating the effects of rising rates is to lower the maturity and duration (interest-rate sensitivity) of your bond holdings, and set up a "ladder" of individual bonds and ETFs that mature over the next several years.

The Vanguard Short-Term Bond ETF (BSV) and its mutual fund cousin (VBISX) track an index of corporate and government investment-grade bonds with an average maturity and duration of less than three years. The ETF yields 1.5%. (I own the fund.)

As I reported last week, Vanguard is moving assets in some target funds out of longer-dated TIPS and into the Vanguard Short-Term Inflation-Protected Securities Index (VTIPX, and the ETF version is VTIP.) VTIP's average duration is 2.5 years, versus a whopping 8.5 years for the traditional TIPS fund. The switch is a no-brainer.

Read Howard's take at MoneyShow.com on whether investors should still buy TIPS.

If you like high-yield bonds but want shorter maturities, the Pimco 0-5 Year High-Yield Corporate Bond ETF (HYS), with an average duration of 1.9 years, should do the trick. For investors close to or in retirement, try a laddered portfolio of bonds or ETFs maturing over each of the next few years.

iShares has just rolled out four investment-grade bond ETFs maturing in 2016, 2018, 2020, and 2023. Splitting some of your bond money between the 2016 and 2018 funds might make sense, but since these are new, you need to do more research.

Among individual bonds, Marilyn Cohen likes AutoNation's (AN) 6.75% bonds maturing in April 2018, which yield 3.66%. "You want to be in an industry that is thriving, with a company that has a good CEO and profitability over the next few years," and the high-yield AN bonds fit the bill, she said.

She also likes the 6.875% June 2018 Arrow Electronics (ARW) bonds, yielding 3.24%. They're at the low end of the investment-grade scale, but in this case, boring is beautiful. "I'm not looking for excitement," said Cohen.

Nor am I—we've had too many thrills and chills in the markets already. But something tells me the fun is just beginning again, this time in bonds.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and attend his workshop, "Your Ideal ETF Portfolio for Now," at the MoneyShow San Francisco, August 15-17. For more details, click here.