Bonds typically don't grab as many headlines as stocks do, but the recent rally that sent yields to four-decade lows pushed the fixed-income market to the front of investors' minds.

And the bond market certainly has been garnering investors' dollars. In the first quarter of 2003, bond funds took in a record $43.5 billion, while equity funds saw a $5.9 billion outflow. Just last week bond funds took in another $1.7 billion.

On Tuesday, a rumor that the Federal Reserve might make a rate cut prior to its next scheduled meeting on June 24 sparked another rally, pushing the yield on the 10-year note down to 3.41% and the five-year down to 2.35%.

Even with the recent rally in stocks, bonds have provided better returns for the past one- to three-year period. But since yields can only go to zero, we are truly nearing a point of diminishing returns and increasing risk, which has many investors looking for ways to protect or profit from a rise in interest rates.

The ETF Angle

In January I took a look at using bond futures and their options as speculative, hedging tools regarding the direction of interest rates. At the time, the 10-year was trading at 4.05%, but the June futures price reflected a yield of 4.50%, as the consensus opinion was that rates would be climbing over the next six months. Aside from showing just how wrong the futures market can be, it also highlighted one of the difficulties of using futures to hedge a cash position.

Now I'd like to present a relatively new product that I think offers an efficient and cost-effective alternative for hedging a bond portfolio -- exchange-traded funds based on bond indices. Barclays brought out the first batch in August 2002, offering three Treasury funds: iShares Lehman 1 to 3 Year Treasury Bond Fund ( SHY), iShares Lehman 7 to 10 Year Treasury Bond Fund ( IEF) and iShares Lehman 20+ Year Treasury Bond Fund ( TLT). On April 28, options became available on all three of these ETFs.

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