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Investors have generally been warned not to expect big profits from bonds. While price gains on bonds can sometimes rival those of stocks, that generally happens only when interest rates are falling, and rates are more likely to rise today, causing bond values to fall.
But investors with a taste for the wild side can make money betting against bonds, profiting when prices go down as you might do by short selling or buying "put" options on stocks.
Generally, it's a game for sophisticated traders, but it's become easier for small investors in recent years with the growth of exchange-traded funds that own bonds. So, if you think interest rates are likely to go up, you could make some money if you're right.
Peng Zhou, managing director of Sun Life Investment Management, expects the Federal Reserve to raise short-term interest rates several times in the next year to head off inflation as the economy gets stronger, undermining values of short- and intermediate-term bonds.
The easiest way to guard against losses in fixed-income securities is to own fewer of them, says Salvatore Russo, head of research for EMM Wealth, a multi-family office in New York. Another common strategy: own bonds with shorter maturities, as they are less sensitive to interest rate changes.
Russo notes that while it is possible to make money on falling yields like the pros, the strategies are tricky for amateurs.
"There has been a proliferation of ETF, mutual fund and structured products designed to protect fixed income from rising interest rates, but the inexperienced investor should consult with a financial professional first to help determine what would be suitable," Russo says. "Be wary of these products. Many are high in fees, unproven and can expose investors to additional credit, illiquidity and counterparty risks."
The first thing to understand is the inverse relationship between bond prices and interest rates – as prevailing yields rise, prices drop for older bonds traded in the secondary market.
Suppose you'd paid $1,000 a couple of years ago for bond yielding 2 percent. It would pay you $20 a year until the bond matured and you got back your $1,000 principal. But if newer bonds paid 4 percent, $40 a year, you might be able to sell the old one for only $500, the price at which $20 equals a 4 percent yield.
In the real world, it might not be quite so bad because of other factors, like how long the bond had to mature and the interest you could earn reinvesting that annual income. The point is, changes in interest rates can have a dramatic effect on bond values.
Fixed-income investments are a vital part of a portfolio.
It works the other way, too, with falling rates lifting prices of older bonds. A gradual decline of interest rates made bonds a good long-term investment over the past 30 years.
Now, however, rates are more likely to rise. One way to make money when bond prices fall is a short sale through your broker, but a beginner with a small account may not be allowed this strategy. If you could, you'd borrow a bond to sell at today's price and hope to replace it with one bought cheaper sometime later, profiting on the difference.
Or you could bet on the futures market, which involves promising to buy or sell an underlying security like a bond at a set price on a given date. Like a short sale, this is complicated for a beginner, requiring a lot of knowledge, attention and willingness to take risk.
Some mutual funds are set up to make money on falling bond prices, including the Guggenheim Inverse Government Long Bond Strategy (ticker: RYAQX).
But the fund industry now offers another option with exchange-traded funds, which are like mutual funds but are traded like stocks. Instead of owning actual bonds, some of these ETFs contain futures and other derivatives the investor need not fully understand. You just bet on the ETF's broad strategy, hoping the ETF share price will rise as bond prices fall.
ProShares is a major player in this area, offering ETFs like the ProShares Short 7-10 Year Treasury (TBX) that shorts U.S. Treasury bonds with seven- to 10-year maturities. (Note that ProShares warns the fund is meant for short-term trading, not buy-and-hold.)
As Russo cautions, many mutual funds and ETFs that offer inverse returns have high expense ratios, often exceeding 1 or 2 percent.
Other ETFs are more straightforward, owning a basket of bonds of a certain type. Because ETFs are traded like stocks, they can be sold short, something you cannot do with ordinary mutual funds. While the ETF would lose value with rising rates, you could make money by replacing your borrowed shares with ones purchased for less.
Also, many ETFs have options contracts, just like stocks. So you could buy a put option giving you the right to sell the ETF shares at today's price on some future date. The contract would rise in value if falling bond prices depressed the value of the ETF shares.
Stephan Unger, economics professor at Saint Anselm College, says there also are some exotic products for investors with more complex ideas about how rates will change, such as the iPath U.S. Treasury Steepener exchange-traded note (STPP). It bets that prices will rise on 2-year Treasurys and fall on 10-year Treasurys, which would happen if long-term rates go up more than short-term ones.
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