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.

These securities basically comprise 10 to 13 different Treasury issues with a variety of yields and durations, with the blended total generally corresponding to the price and yield of the related Lehman bond index. These indices provide a great tracking mechanism for bond yields and offer a fair representation of a typical investor's bond portfolio.

One of the attractions of trading ETFs is that it provides investors the ability to buy into or short a pool or basket of holdings with a single transaction. Also, bond ETFs offer the simplicity of stock trading, which can be comforting for the many investors who are intimidated by the notion of trading futures or who are reluctant to open a commodity account.

"iShares bond ETFs offer investors one of the best value propositions among bond investments today," says Steven Haberman, a portfolio manager with One Focus, a Chicago-based money management firm. "They provide investors compelling benefits -- diversification, transparency in portfolio holdings and intraday pricing."

Options on the ETFs are priced and traded just like equity options, with each contract representing 100 shares of the underlying security. The volatilities are very low, making these options relatively cheap to purchase.

For example, with iShares Lehman 7 to 10 Year trading at 89, the December 2003 at-the-money 89 put is being offered at $2.75, giving it an implied volatility of just 13.5%. This allows you to buy put protection for a $100,000 bond position for about 5.5% a year.


Interest and Bonds
This ETF has drawn investor dollars


That rate compares favorably to the nearly 12% annual cost of protecting a stock portfolio through the purchase of S&P 500 Depositary Receipts ( SPY) put options. For a review of how these calculations were made, please see this previous article on hedging strategies.

Be aware that these products have low trading volume and nearly nonexistent open interest. The above-mentioned December 89 put has just 125 contracts open. I assume this lack of liquidity is mainly due to the fact that the options began trading less than three weeks ago, and I suspect we'll see higher volumes as more investors become interested. But in the meantime, approach these options with caution.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to Steve Smith.

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