Column: Ways to hedge your bets in the bond market smackdown

CHICAGO Fri May 31, 2013 2:25pm EDT

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CHICAGO (Reuters) - For investors who piled into bond funds this year, the past week has been an abject lesson of how to get bruised in short order.

An uptick in yields smacked bond prices, which move inversely to yields. Funds investing in high-yield and long-maturity issues got hit the worst. Yields on 10-year Treasury notes hit a peak of 2.23 percent, the highest since April of last year, before dropping to 2.16 percent on Wednesday.

The pre-June bond swoon is a harbinger of things to come. The U.S. economy is heating up after years of decline, which will trigger greater demand for credit and lower bond prices.

The good news? There are a bevy of alternative vehicles to help you hedge bond price declines.

But first, some things to consider: Bond yields have largely been watered down by the Federal Reserve's bond-buying program in an effort to grow employment and the economy since the 2008 market and credit meltdown. The U.S. economy grew 1.7 percent in 2011 and 2.2 percent last year.

The U.S. is expected to grow nearly 2 percent this year and about 3 percent in 2014, according to a report released on Wednesday by the Organization for Economic Cooperation and Development (OECD), which added fuel to the credit market flare up. The organization said a Fed retreat from its easing program could lead to lower bond prices.

Now traders fear the Fed will take its hands off the throttle of its stimulus engine to slow its bond purchases. That has led to the yips in the most volatile bond funds of late.

"While I don't believe the Fed's bond buying program will imminently cease," said Jack Ablin, chief investment officer for BMO Private Bank in Chicago, "I do think that 'taper talk' will lead to high bond yields. We have been bond skeptics for a while; however, we have added bearish bond positions in income-oriented portfolios."

MOST SKITTISH FUNDS

In recent years, high-yield corporate or "junk" bond funds have been the darlings of income-oriented investors. These low-rated bonds have always had a high risk of default, but have paid healthy yields.

Investors have been well compensated for the additional risk, which is closely linked to the stock market. Yet that risk can be biting. One of the largest junk-bond ETFs - the iShares iBoxx $ High Yield Corporate Bond fund - lost more than 1 percent in a week through May 29. It's up almost 3 percent year to date and yields 6 percent.

The SPDR Barclays High Yield Bond Fund, has had similar troubles, losing 1 percent in a week. It's gained 3 percent year to date and yields 6 percent. Keep in mind that these funds will always be subject to amplified volatility, so they should only be small holdings in your income portfolios.

Most bond investors, though, probably sample the broad section of the U.S. bond market through a giant index fund such as the Vanguard Total Bond Market Fund, which yields about 1.6 percent. It's also feeling the sting of lower prices, though, having lost 0.47 percent in the past week and 0.76 percent year to date.

HOW TO HEDGE BOND MOVEMENTS

Not all bond funds react the same to rate moves. Those with a shorter duration - which measures a bond's sensitivity to interest-rate moves - will hold their value better than long-maturity (20 years or more) or junk bond funds. The iShares 1-3 Year Credit Bond ETF, which holds short-term corporate debt, lost only 0.05 percent in the past week and is up 0.47 percent year to date. With this lower risk profile, though, comes a much lower yield of 1.5 percent.

There are a bevy of alternative vehicles that can help you hedge bond declines. I've always liked I Savings Bonds, which are linked to the consumer price index. If inflation comes back, you will earn the current Treasury yield plus a bonus rate pegged to the U.S. cost of living. You can buy them for as little as $25 commission-free through Treasurydirect.gov. Interest is compounded semi-annually for up to 30 years.

If you're working with a trusted adviser or want to do something daring, you can employ a hedging strategy using inverse ETFs. The prices on these vehicles rise when bond prices fall.

You can "short" nearly any kind of bond. For example, let's say you owned long-maturity government bonds and wanted to protect yourself. You could buy an ETF such as the ProShares Short 20+ Treasury ETF, which was up about 1 percent in the past week and gained 3 percent year to date.

Just keep in mind that these vehicles are more volatile than junk-bond funds when rates are low or falling. The ProShares fund has lost an average 12 percent over the past three years.

The simplest approach, though, is to buy a diversified portfolio of the highest-rated individual Treasury, corporate or municipal bonds through a deep-discount broker. When yields rise, find the bonds with the best coupons and hold them to maturity.

(The story corrects name of ProShares Short 20+ Treasury ETF in paragraph 16 and adds explanation of duration)

(Editing by Lauren Young and Andre Grenon)

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