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Protecting bond income

In one of our past articles we discussed at length how the Fed was implementing Quantitative Easing (QE2) to keep interest rates low in hopes of improving the overall economy. We also discussed how this program might lower the price of bonds and create an environment less friendly to bond investors. Yes, rates have inched up, but if you bought bonds the value of those bonds may have started to slide a bit. Since the middle of December the price of the 10-year treasury bond has fallen as have most bonds held in investors' accounts. 2010 was a great year to own bonds; so far in 2011 it has not been helpful to your overall portfolio's value to own them.

The ease of investing in bonds through mutual funds and Exchange-Traded Funds has many advantages versus building a portfolio out of bonds. You get a greater amount of diversification using bond funds as well as an average maturity schedule. You can also invest in many different types of bonds using ETFs: high yield, municipal bonds, short duration, treasuries, as well as investing across many different sectors. All of these ETFs spread your risk across the board and may provide your portfolio limited risk to one specific bond type.

As interest rates rise and the value of bonds declines, a lot of investors will sell their bond ETFs and hold the funds in a cash account and weather the storm until yields have increased and the bottom of bond prices has stabilized. Now the investor has shut off what may be a very important income stream. But does liquidating your bond portfolio make sense?

One strategy often overlooked is hedging your bond portfolio. Yes, we used the word hedging. There are no doubt investment company compliance officers sweating bullets at the mention of implementing a hedging strategy. So to calm their fears we will use a more soothing term--insuring your bond portfolio. Now, let's look at a possible strategy using the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) and the Direxion Shares Daily 7-10 Year Treasury Bear 3x Shares (TYO).

Using a $100,000 portfolio that in 2010 purchased $100,000 of the LQDs in October, you purchased 909 shares. Most likely you paid around $110 per share for the LQDs that were paying approximately .43367 cents per month per share. Your monthly income was $394.20, which should translate into a yield of 4.7 percent. As of Feb. 7, 2010, the price per share has fallen to $107.23 per share. Your initial investment has fallen in value to $97,472.

But would making a small change to the portfolio help to protect the value and protect the income? Going back to the date of purchase, understanding the dynamics of the bond market and gathering good advice buying the LQDs made perfect sense and was a wise decision. But things changed in the bonds market in mid-December 2010. From a technical analysis standpoint the 10-year T-Note broke support and was clearly in a downward trend. The LQD mirrored the same technicals and showed clear signs of weakness at $109 per share. Combining the two technical clues and applying some fundamental thoughts about interest rates having to rise in the future, it made sense to review your bond investments.

Selling was an option, but most people don't make that decision easily and act on it. But hedging the bond portfolio made sense, and still might today. When all of the indications were pointing toward a decrease in bond prices, one strategy would have been to use an inverse ETF directly correlated to the type of bond portfolio you own to insure its value. Here is how it works.

The TYO ETF is three times the inverse of the 10-year treasury. Simple explanation: If treasuries drop 1 percent in value the TYO should increase 3 percent. Here is how it works: In mid-December you sell the proper amount of your LQD shares to purchase $24,743 worth of the TYOs at a price of 43.50 per share. Now fast forward to today. Because you own less shares of the LQDs, the monthly income dropped to $291.26 per month. The value of the LQD fell to $73,130 while the value of the TYO shares increased to $30,906. Your total bond portfolio, if liquidated on Feb. 7, 2011, would have been worth $104,036.

You sacrificed $102.94 per month of income to implement this strategy. But what did you gain? The original buy and hold strategy gave you a monthly income of $391.20 and a value of $97,472.00 on Feb. 7, 2011. By managing the risk you decreased your monthly income by around $100 per month for two months but actually boosted the value of your portfolio. So what is the next move?

Maybe it's time to lift the hedge. Are interest rates and bond values stable for the time being? If so, sell the TYOs and buy back into the LQDs. But you now have around $4,000 more that should earn you some additional income. Or maybe keep the hedge in place to continue to protect the portfolio.

In order to appease our compliance department we must let you know in plain English that this strategy is not for everyone and is for educational purposes only. We are not recommending you implement this strategy without seeking advice from your current adviser. Our objective is to provide you with strategies that given proper thought and due diligence may work for your individual investment portfolio. We also recommend that you do your research on the investments we mentioned. Please visit www.ishares.com and direxionshares.com.

Editor's note: Agvisors provides commentary about agricultural markets, including grain, dairy, livestock, equities, financials, and energy, highlighted by a live weekly webinar discussing conditions and responding to questions. For more information, visit http://agvisors.com.

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