A Hot New Income Play

hotIt’s hardly news that there is a dangerous bubble in the bond market. When debt-ridden Uncle Sam can borrow for 10 years at 1.8% and 30 years at 3.1%, something is clearly amiss. The cause, of course, is Federal Reserve intervention in the bond market. Ben Bernanke is spending hundreds of billions to buy longer-term bonds and force interest rates down.

Pundits will argue about whether this is ultimately a good thing or a bad thing, but there is no denying that in the short run this has given the stock market and the housing market a shot in the arm.

Mortgage rates are near record lows. And with cash paying next to nothing – if not nothing itself – investors are moving into stocks and riskier bonds.

The question for investors, of course, is what will happen when this Fed stimulus ends.

Since it will signal that the Fed believes the economy is strong enough to continue growing without intervention, the Fed’s exit will be a neutral factor for the stock market.

But it will create turmoil in the bond market.

Prices Will Plummet

Picture a seesaw. Interest rates and bond prices are inversely correlated. When interest rates go up, bond prices go down. And vice versa.

So when the biggest player in the bond market – the U.S. Federal Reserve – quits holding rates artificially low they are going to spike higher. And that’s not good for bonds.

Prices will plummet.

How does a fixed-income investor protect himself? There are several ways.

The first is to limit overall exposure to the bond market. Anyone who has half or more of his liquid net worth tied up in historically “safe” bonds – like Treasurys and high-grade corporates – is going to get his head handed to him.

However, it’s important to remember that if you buy a bond at par ($1,000) and interest rates go up, the drop in the market value of your bond (assuming there is no default down the road) is merely temporary. You can ride out a rising interest rate environment and recover your full investment at maturity.

But most fixed-income investors don’t have enough capital to diversify in individual bonds. And there’s the rub. If you own a bond fund, even a U.S. government bond fund, there is no assurance that you will get your principal back ever.

Why?

Because the vast majority of funds are forced to keep buying new bonds as interest rates rise. And that means the net asset value will stay under continued pressure.

Fortunately, an innovative new investment vehicle protects you from this problem.

They’re called defined-maturity exchange-traded funds (ETFs).

If you haven’t heard about these, it’s probably because most were only recently launched. They solve the rising interest rate conundrum for bond fund investors.

For example, if you want to buy short-term investment-grade corporate bonds, you might try the Claymore Exchange-Traded Fund Trust (NYSEARCA:BSCF), maturing on Dec. 31, 2015, and currently yielding 1.93%.

Or, if you prefer the tax-free route, you might try the iShares 2017 S&P AMT-Free Mun Ser ETF (NYSEARCA:MUAF), maturing Aug. 31, 2017.

If you want more yield – and are willing to take more risk – you might try the Claymore Exchange-Traded Fund Trust (NYSEARCA:BSJI) with a maturity date of Dec. 21, 2018, and a current yield of 6%.

There are other funds like these to choose from and – gauging by their popularity – many more to come. But the key advantage here is that you can collect the bond’s face value at maturity.

I can’t emphasize enough that closed-end funds and open-end mutual funds don’t mature – and neither do 99.9% of all ETFs. So these funds are truly offering something new and better.

And that something is hard-to-find fixed-income protection against rising rates. And – trust me – it’s only a matter of time.

Good investing,

by Alexander Green, Investment U Chief Investment Strategist

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