Should You Hedge Your Bond Holdings?

09/26/2011 6:30 am EST

Focus: BONDS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Investors must be sure they understand that their bond holdings have risk, and a hedging strategy is very prudent, cautions Successful Investing’s Doug Fabian in this exclusive interview with MoneyShow.com.

Doug, I thought that if the S&P downgraded debt, interest rates might rise, and that was totally wrong. What’s going on?

It’s amazing how the market can be so counter-intuitive. I thought like you did, Karen. I did not anticipate the rise that we saw in bonds of late, but I think underlying there’s an opportunity and risk here.

Let’s talk about the risk. Treasury bonds have been a safe haven in this European-led crisis because a lot of money has flowed out of Europe into US banks and the US bankers have turned and said, "What am I going to do with this money?" So they put it into US bonds, and we spiked US Treasury bonds 5% to 7% in value in August.

I think that here is both a risk and an opportunity. The risk is, investors should not perceive their bonds as being flawless or risk-free investment vehicles, because if we do have a reversal in interest rates because they are so low…

No, I’m not talking about the Fed raising interest rates, I’m just talking about interest rates in the marketplace and people wanting now to sell their bonds to bank profits, or if that money starts to flow back into Europe, you’re going to have that risk premium come out of the bond market.

It’s very important for people to focus on municipal bonds, especially municipal bond funds, I think that they are risky. If S&P does start to downgrade some municipalities, or we start to get into a new trend of lower bond prices in municipals, you get into this redemption cycle where people are pulling money out of bonds. If you’re kind of late to taking action it’s difficult.

Now here’s the opportunity. The opportunity is, and we use this for our clients who are income-oriented, where we need bonds in the portfolio to create income, but we’re worried about higher interest rates.

We add an exchange traded fund that is a hedge, the ProShares Short 20+ Year Treasury (TBF). This is a single inverse to the Treasury bond, so if you have 30% of your portfolio in bonds, let’s say corporate bonds and aggregate bonds, those kind of things, you could at a 10% position in TBF and offset your interest-rate risk on those bonds and still get your income.

You’re keeping your portfolio stable, TBF may rise, your bonds may fall slightly, but you still get that income stream, which is what many people are invested in bonds for anyway.

But we’re in a very-low-interest-rate environment. If that cycle reverses, you’ve got to be careful with your bond funds.

What would give you the key that the cycle has reversed?

Well, if you watch the exchange traded fund iShares 20+ Year Treasury Bond Fund (TLT). TLT represents if you owned 20-year Treasury bonds. If that starts to reverse in price, that’s going to be your indicator that there is a change in that trend.

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