Your Money: Ways to counter dropping bond prices

Investors across America are grossly unprepared for losses in fixed income, even though individual mom-and-pop investors and retirement-plan participants hold $5 trillion in bonds.

Individual and defined-contribution investors are the most exposed and aren't ready to withstand losses in this area of their portfolios.

When bond prices drop - as they undoubtedly will when interest rates rise - U.S. investors facing uncertain bond markets will likely shift $1 trillion of assets currently allocated to traditional fixed-income products to debt, including global and emerging-market bonds, high-yield and loan portfolios, alternative fixed-income products, and vehicles designed to protect investors from inflation and rising rates. At least that was the strategy encased in a report last week from Casey, Quirk & Associates, an investment management consultant.

The New Jersey State Pension Fund is already shifting its allocation, according to Timothy M. Walsh, director of the investment division and chief investment officer of the pension fund, in an interview with investment guide Pensions and Investments.

Because of a poor environment for returns, Walsh reduced core fixed income by 5.4 percent, or $3.4 billion, to a 14.3 percent allocation in the year ended April 30, and likely will reduce that percentage further.

How can the rest of us prepare? If you want to simply sell your Treasury or other bonds, that's one way. But most people still need income and might not want to do that.

If you want to make an actual bet on the Treasury price falling, there are a few ways. Investors can buy put options on an exchange-traded fund (ETF) like TLT, the iShares Barclays 20+ Year Treasury Bond Fund.

There are also leveraged exchange-traded funds that allow investors to "short" Treasuries - basically, bet the prices will drop. Leveraged or inverse ETFs like ProShares Short 20+ Year Treasury, or the Direxion Daily 20+ Year Treasury Bear 1x Shares, are handy for short-term trading. But leveraged ETFs often don't accurately track the movements of the underlying investment, and they have higher fees.

The longer the duration of the bond ETF, the more the ETF will rise or fall in value when interest rates change.

The site www.learningbond.com explains:

"Duration measures the sensitivity of a bond's price to a move in interest rates. If a bond has duration of 5 (five years) and interest rates move up by 1 percent, the bond's value will fall by 5 percent. The further a bond's maturity date is in the future, the higher its duration."

In the case of a bond with a duration of 8, a 1 percent rise in market interest rates would cause the bond to decrease in value by 8 percent. Conversely, a 1 percent decline in the interest rate would cause the bond's value to increase by 8 percent. The longer a bond's duration, the greater the impact an interest rate move will have on a bond's price.

One note on buying an ETF with a very high duration: you will not need leverage - using borrowed money to increase your investment in prices moving higher or lower - to turn a modest interest rate move into a big profit or loss.