ETF bondsThe economy is looking better, but debt has skyrocketed and fears of eventual inflation haven’t subsided. That’s where the Federal Reserve comes in to kick up interest rates. Bond exchange traded funds (ETFs) – beloved in the first quarter – may get socked if you’re not looking. What can you do about it?

Bond investors poured $375 billion into bond funds last year, and another $54 billion in the first two months of this year, reports Walter Hamilton for The Los Angeles Times. All that cash could be at risk when the Federal Reserve raises rates later this year. When market interest rates rise, the value of fixed-income securities start to fall. What’s a fixed-income fan to do? [Interest Rate Hike Impacts Bond and Equity ETFs.]

History has shown that bonds, especially long-term ones, take a hit from rising rates. Investors prudently put more money into intermediate- and short-term portfolios this time around. What happens next is a matter of debate:

  • Short-term bonds could be at greater risk than long-term bonds since bond rates have to do more with the marketplace.
  • If bond investors see that rate hikes will head off inflation, demand for long-term bonds may increase.
  • If the Fed raise rates too quickly, long rates could come down.
  • Short-term bonds, on the other hand, have yields that are so low that they can’t do much to offset a drop in value. [Why It’s Time to Approach Bond ETFs Differently.]

High-yield bonds may be one refuge for bond investors since the higher yields of junk bonds can do more to offset a drop in market value. Additionally, an improving economy is good for junk bonds since it lowers risk of defaults. However, junk bonds are usually more volatile than other bond funds. [Who’s Driving the Bond ETF Market?]

The Office of Management and Budget projects the rate on the benchmark 10-year U.S. Treasury note to remain near 3.9% for the rest of the year, but it will rise to 4.5% in 2011 and 5% in 2012, reports Nelson D. Schwartz for The New York Times. Furthermore, the issuance of new debt to finance the government’s already huge deficits could pressure demand, pushing rates even higher.

As the interest rate situation sorts itself out, it’s imperative for you to be prepared to act when it happens. Just know that it’s coming, and sooner rather than later.

For more information on bonds, visit our bond category.

  • Vanguard Short-Term Bond (NYSEArca: BSV)
  • iShares Barclays 1-3 Year Treasury (NYSEArca: SHY)
  • SPDR Barclays Capital Short-Term Corporate Bond (NYSEArca: SCPB)
  • iShares iBoxx $ High Yield Corporate Bond (NYSEArca: HYG)
  • SPDR Barclays Capital High Yield Junk (NYSEArca: JNK)
  • ProShares UltraShort 20+ Treasury (NYSEArca: TBT)
  • Direxion Daily 30-Year Treasury Bear 3x (NYSEArca: TMV)

Max Chen contributed to this article.