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How to Survive the Bond Fund Crash

Roger Nusbaum

NEW YORK ( TheStreet) -- The last few weeks have been rough for equities and fixed income. The most notable decline has been the 20% decline in the Nikkei 225 Index in just 17 trading days. Interest rates have also moved up in the last few weeks on concerns of a so called tapering by the Fed which has hurt just about every type of yield oriented fund.

For years now many market pundits have been calling for rates to normalize back to higher levels and when this occurs it will likely result in serious price declines. It is impossible to know whether that has started yet but the market is trading like it is possible. One segment that has been hit has been closed end funds. In the last three weeks the PowerShares CEF Income Composite Portfolio has dropped more than 7%.

Closed end funds issue a set amount of shares so a large wave of selling or buying in the open market can cause the quoted market price to deviate from the net asset value of the underlying portfolio. This dynamic means that closed end funds are often prone to panicked moves even when the fundamentals of the portfolio are still sound. In the last month the PIMCO Corporate Bond Opportunity Fund is down 15% compared to less than a 2% drop for that fund's net asset value. There are plenty of other closed end funds that have put in similar showings in the last few weeks.

Declines of this nature are a crash. Every so often segments like closed end funds, or MLPs, or preferred stocks and any other specialized segment go through violent selloffs and these selloffs always result in people realizing they did not understand the risk they were taking until after the large decline.

In the last few years investors have sought out more exposure to closed end funds and other high yielding products because interest rates for CDs and investment grade corporate bonds have been so low. It has been said that the Fed has punished savers by forcing them into riskier assets to get their yield. This is of course what is known as chasing yield and chasing yield almost always ends in lower prices and shocked investors.

A key building block of understanding is that in a 0% world a fund or individual issue that yields 8% carries risk and can go down a lot very quickly. A portfolio with nothing but 8% yielders could easily be down 15% in the last month which is enough for some investors to panic sell.

While an entire portfolio of 8% yielders is risky, some exposure to these types of funds along with less interest rate sensitive funds like the Guggenheim BulletShares 2015 Corporate Bond ETF or the iShares 1-3 Year International Treasury Bond ETF make for better diversification and should reduce overall fixed income volatility. In the last month BulletShares is only down 0.43% and ISHG is actually up 2.89%.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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