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How to Hedge a Bond Portfolio

Original post by Walter Johnson of Demand Media

A bond represents a loan you have made to a government or firm. Its profitability depends entirely on present and future interest rates. A bond has several components, but in terms of value, the predicted course of interest rates is crucial. If rates are predicted to drop, then the bond becomes more valuable, since its issued interest rate is now higher in contrast to the predicted future rates. A hedge is a means of protecting the value of an investment by using additional investments to make up for any losses in other areas of your portfolio.

Contents

Step 1

Buy a mix of short, medium and long-term bonds. Long-term bonds contain a risk premium, which means that the rate of return on these bonds is higher because long-term interest rates are very hard to predict. If you have a number of long-tern bonds and your short-term bonds lose value because of a predicted rise in rates, the risk premium for the long-term bonds will cover any losses. If your short-term bonds lose value, the value of your medium-term and long-term bonds might increase, since a prediction of rising rates is normally accompanied by a prediction of their lowering further into the future. Therefore, when hedging bonds, the mix of different durations is essential.

Step 2

Buy gold. If there is a prediction of instability in the bond market, gold will serve as a hedge against any losses. The more jittery a market becomes, the more important gold becomes as a hedge. As of the summer of 2011, the markets lack confidence. As gold has skyrocketed in value, buying it now still seems rational, as Goldman-Sachs, among others, predict its continual rise in 2012 and beyond. Because gold increases signal that investors do not have confidence in the money markets, continual increases into 2012 might mean more instability. Even if gold were to decrease, buying gold as a hedge still makes sense since future instability might see further increases in price. Keeping some gold in reserve is always a good idea no matter the condition of the market. Other commodities such as oil or gas might also serve as a similar hedge against uncertainty.

Step 3

Buy strong, state-controlled currencies abroad. The Chinese yuan seems to be an excellent bet. Since the state controls its value, market forces, in general, will have little effect on it. The Chinese government has a long-term currency stabilization policy, and its vaunted economic success guarantees that it will retain value. If most or all of your bonds are in dollars, hedge this with currencies controlled by the state.


                   

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About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."


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