How to profit from bond turbulence

As I noted in January, five of the top seven European exchange-traded funds (ETFs) last year by sales were bond funds, suggesting the type of exuberance that often signals a market top. Sure enough, in the last three weeks we've seen the biggest outflows from bond ETFs since 2008. The Bank of England's director of financial stability, Andrew Haldane, admitted recently that central banks have blown a bond bubble.

Near-zero interest rates and quantitative easing have caused investors to do two things: assume central banks have taken away market risk; and chase yield by buying any bonds, the junkier the better. But I agree with Haldane that this is a potential recipe for disaster. So if you own bonds or bond ETFs, where are you most exposed and what can you do about it?

First, if interest rates do rise the only way you can be protected from capital losses is to hold cash or very low-risk bonds (typically those with a relatively short maturity). You can hold short-maturity bonds via ETFs, but the yield you earn after fees is small. For example, iShares' FTSE 0-5-year gilt fund (IGLS) earns you only 0.54% in interest a year after fees. As this type of fund is exposed to some capital risk, you're probably better off keeping cash in a bank account, provided you are below the Financial Services Compensation Scheme's limit of £85,000.

If you own government bonds of longer maturities you are more exposed to rising rates, so consider shortening your exposure or selling. Where you are most at risk is in high-yield and emerging-market bonds, segments of the market that have seen huge inflows during the last few years. Liquidity here can dry up fast when times get tough. And although you are invested in bonds, your risks are akin to holding equities. For example, iShares' Barclays Emerging Markets Local Government bond fund is down 14% in just six weeks. Nonetheless, if you own popular high-yield ETFs such as iShares Markit iBoxx Euro high yield bond fund, it's probably not too late to cash in.

The bravest investors could turn the tables and attempt to profit from falling bond prices (and rising yields) using one of the inverse ETFs offered by Deutsche Bank. For example, db x-trackers' short gilt (XUGS) and short US Treasury (XUTS) both benefit if rising rates send bond prices down. For real bond bears, these are worth a look.

Paul Amery is a freelance financial journalist, formerly a fund manager and trader. His website is Paulamery.net.