Investors Should Consider Protecting Their Bond Portfolios

nvestors, and their investment advisers, should consider protecting, or hedging, the gains in their bond portfolios.

2002 was a good year for bonds, as measured by four relevant indexes. The Lehman Brothers Long Term Treasury index had a 16.79% rate of return for 2002. The Lehman Brothers 1-10 Year Municipal Blend index gained 8.68%. The Merrill Lynch 1-3 Year Treasury index rose 5.76%. Finally, the Lehman Brothers High Yield Bond index declined a modest 1.41%. By comparison, the S&P 500 saw another significant decline, 22% in 2002.

Now what? Many investors have seen significant equity portfolio gains wiped away since 2000. Should investors similarly just "hold on" for the next roller coaster ride, this time in bonds?

I recently had the pleasure of reviewing material from Bank of America's Global Derivative Products Division, entitled, "Taxable-Exempt Bond Portfolio: Protecting Imbedded Gains." According to the material, investors can hedge a fixed rate tax-exempt bond portfolio (and other types of bond portfolios as well). This struck me as a very sensible suggestion, given that some well-advised investors over the last few years were able to hedge their equity portfolios (such as protecting concentrated holdings resulting from the exercise of employee stock options in technology company shares).

The choice for bond investors, of course, is as follows: do nothing; sell the bond portfolio (thus realizing the portfolio gains but losing what is an attractive income stream); or hedging. Hedging would allow the investor to protect a significant portion of the imbedded gains and to continue receiving an attractive income stream.

The material also highlights the types of risks associated with a bond portfolio. To review, they are credit spread risk (bond values decline if a bond's rating decreases); interest rate risk (as interest rates rise, bond values fall); reinvestment interest rate risk (new bonds purchased may not pay as high a coupon, or interest); and call risk (some bonds may be redeemed prior to maturity, usually when interest rates have fallen, creating reinvestment interest rate risk).

The hedging strategy proposed is complicated and beyond the scope of this article. But consider these points discussed in the materials. First, clients who wish to buy and hold to the bonds' maturities may not wish to hedge. Second, a "laddered" bond portfolio (where investors purchase several bonds with different maturities so that, each year, one of the bonds in the portfolio matures) is only a partial hedge, because of reinvestment interest rate risk described above. Third, the longer the duration of the bond portfolio, the greater the risk of the bond portfolio, and the greater the need to hedge the imbedded gains in the bond portfolio.

A final observation is that this derivatives-based hedging strategy is practical only for sizable bond portfolios. These transactions are not "off the rack" but instead are custom created for the particular bond portfolio. Additionally, master agreements, schedules and other legal documentation must be negotiated and agreed upon.

Nonetheless, the effort may well be justified due to the anticipated benefits of the hedging strategy. "Here today, gone tomorrow", is not what investors want to experience!

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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is a past co-chair of the Chicago Bar Association's Securities Law Committee, a past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat & Filipowski and can be reached at 312-621-4400.