How to Hedge a Bond Portfolio

The primary rule of bond investing is: as interest rates rise, bond prices fall. Hedging a bond portfolio protects it, to some extent, from rising interest rates. A hedge shields you by increasing in value as your portfolio declines, but hedging can be expensive and only partially effective. If you feel the need to hedge, it makes sense to identify and prepare for what you anticipate might occur.

If you think rates are about to rise, consider a “dumbbell” allocation of your bonds – heavily weighted at each end of the maturity spectrum. In this strategy, you load up on short-term and long-term bonds, but avoid bonds with intermediate maturities. If your portfolio is about 75-percent short term and 25-percent long, the short terms will be quickly reinvested at higher rates while the long-term debt delivers current high income.

The risk is that if rates fall, your overweight position in short-term bonds will not benefit as much as will a position in intermediate and long-term bonds.

Treasury Inflation Protected Securities, or TIPS, are very safe because they have no default risk, and they rise in value as inflation increases. These bonds pay interest semi-annually and at the same time receive a principal boost from the Treasury if the Consumer Price Index has increased in the last half-year. Not only does this increase the value of the bond, it also creates a larger base upon which interest is earned. The downside to TIPS is that they tend to become more expensive as inflation fears rise.

Corporate bonds that have greater default risk must offer higher yields to attract investors. In weak economies, a diversified portfolio of high-yield bonds can boost your income. As the economy picks up steam, these bonds, which normally sell at steep discounts, are likely to outperform their higher-quality brethren. The reason is that the strengthening economy tends to improve the prospects of high-yield corporate bond issuers, thereby reducing default risk and increasing the prices bid on this debt.

Exchange-traded funds, or ETFs, are baskets of assets that are usually tied to major indices. For example, several ETFs track the S&P 500, such as one offered by Vanguard. ETFs trade like shares of stock on an exchange. They are much like index mutual funds, except they usually have lower fees and often benefit from down markets.

Some bond ETFs are engineered to increase in value as bond prices weaken. Often, these are leveraged – that is, they use debt – so that they rise faster than interest rates. The risk with these is that they can be volatile and lose value quickly if interest rates decline unexpectedly.