How to Hedge Your Fixed-Income Investments

Fixed-income investments seem like a losing bet for now. Interest rates are low resulting in a small amount of income in dollar terms for even the largest investors. A $1 million investment in 30-year Treasury bonds offers about $36,000 a year in income.

This might seem low, but Treasury bonds really have not been a source of high income since about 1986, when rates fell below 9%. Gains for fixed-income investors have come from rising bond prices that accompanied falling rates. When rates rise, prices will fall, and those losses could destroy several years' of worth of low-income payments.

While even investors with million-dollar accounts are earning low income, most investors are earning even less income in dollar terms. To increase income, many investors have accepted more risk. An index of high-yield bonds, also referred to as junk bonds, offers a yield almost 10%.

Junk bonds could fall along with Treasuries as rates rise, although the downside risk seems to be lower. Junk bonds carry an added risk if the stock market falls. In the 2008 market crash, SPDR Barclays High Yield Bond ETF (JNK) fell 47% and remains about 16% below its all-time high.

To offset the risks of loss, fixed-income investors should consider finding a hedge, or an investment that will gain in value when interest rates rise.

ProShares UltraShort 20+ Year Treasury (TBT) is designed to move up in price along with interest rates. Bonds will fall in price as interest rates rise, and inverse bond funds like TBT will rise when bonds fall. As a leveraged fund, TBT moves twice as much as bonds on any given day.

Hedging with TBT could be expensive. In order to fully offset the potential losses, an investor would need to allocate one-third of their fixed-income investments to this ETF. That purchase would reduce current income by one-third but should protect your portfolio against losses in capital if interest rates rise. If interest rates fall, TBT would fall in value, which is an unavoidable risk associated with hedging.

Call options on TBT can reduce the cost of hedging. Traders seem to be expecting interest rates to move up over the next year or so, and the prices of options on TBT reflect that belief.

Call options expiring in January 2015 with an exercise price of $75, near the market price of TBT, are priced at about $11.28. If interest rates on 10-year Treasuries reach 3% from a recent level of 2.7%, TBT could be worth about $97.50, and these options would deliver a gain of almost 100%.

If interest rates fall or remain unchanged, these options would most likely expire worthless.

Out-of-the-money options on TBT -- call options with an exercise price that is above the current market price of TBT -- are trading at prices that make them useful only if interest rates move significantly above 3%.

The most cost-effective hedge is to buy deep in-the-money calls on TBT, i.e., calls that are trading $20 or more below the market price of TBT. For example, January 2015 calls with an exercise price of $55 are trading at about $22.48. If TBT rises to $97.50, these calls would be worth at least $42.50, and the gain would be about 90%.

As long as the 10-year interest rate remains above 2.2%, these calls should retain at least some of their value and reduce the cost of hedging in a declining interest rate environment.

It is important to remember that there is no free lunch with any investment strategy. To protect your capital against losses if interest rates rise, you will have to buy assets that will lose value if interest rates fall.

A reasonable trade-off could be to allocate 10%-15% of your fixed-income investments to long-term call options on TBT. If rates rise, which seems likely given recent Federal Reserve policy statements, these options will gain in value. If rates decline slightly, the losses on the January 2015 $55 calls should be small.

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