Hedge vs. Unhedged Bond

by Lynne Haley Rose
Bonds can play an important role in an overall portfolio.

Bonds can play an important role in an overall portfolio.

Businesses, cities, states, the U.S government and other countries issue bonds to finance many types of undertakings. For investors, bonds are fixed-income securities, because upon maturity, they guarantee the purchaser will recoup the face value plus a fixed rate of interest earned over the life of the bond. However, in a volatile economic climate, an investor may determine that specific bonds, despite their investment advantages, are too risky, and may choose to hedge in order to offset potential losses.

Standard Bonds

One of the advantages of zero coupon investment bonds -- those that pay interest upon maturity -- is low maintenance; an investor can set them aside until they have reached full value. From bonds that pay coupons, or interest, prior to maturity, the investor can expect a pre-scheduled, automatic payment. Additionally, the income generated by many municipal and state-issued bonds is tax-exempt, simplifying annual income tax preparation.

Investment Advantages

Bonds have a fixed value, and return an expected investment return on a predetermined maturity date. The maturity span ranges from 90 days for a short-term Treasury Bill to 20 years plus an additional 10 years of interest accrual for government-issued Series EE savings bonds. Short term-bonds, such as the U.S. "I" bond, typically have a face value purchase price and issue scheduled interest payments with periodic adjustments for inflation. Longer term products, such as the EE, have a discounted purchase price, such as 50 percent of face value, and become redeemable at the face value upon maturity. If the issuing institution remains solvent, the investor can depend upon the solid investment value of a bond.

Hedging Strategy

However, when an unpredictable economy calls the stability of an organization that issues bonds into question, investors may wonder whether their bonds will be redeemable in the long-term. In such situations, investors may wish to hedge their bonds to offset these possible future losses. One simple hedging strategy is to purchase only short-term bonds that offer the advantage of liquidity. Often these investment products are higher risk, but deliver higher short-term yields that allow an investor to buy in, realize a return, and cash out.

Bonds that Hedge Inflation Risk

Specific types of bonds such as TIPS -- Treasury Inflation Protected Securities -- are preloaded with inflation-hedging power. While paying a lower interest rate than standard federal bonds, the issuer adjusts the face value of TIPS bonds according to the rate of inflation. With a raise in the value of TIPS, the fixed interest rate payments will also be higher. While TIPS are not high yield bonds, they do offer the advantage of retaining their value despite downturns in the economy.

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