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Strategies for a falling-bond-prices environment

We're turning the corner after 30-plus years of declining interest rates. Why should we care? Because as interest rates rise in 2017, bond prices are likely to drop.

We're turning the corner after 30-plus years of declining interest rates.

Why should we care? Because as interest rates rise in 2017, bond prices are likely to drop.

The equity markets have recently hit all-time highs. Employment has risen for 74 consecutive months. Wage growth and energy- and food-price inflation are heating up.

Under that scenario, it makes sense to expect rising rates. Some even believe that in 2017, "the Fed will likely lift rates up to four times," says Steve Hovland, director of research at the real estate investment management firm Home Union.

What do we do as investors? Consider TIPS, shorting Treasuries with ETFs, and even high-dividend-yielding stocks as replacements or hedges.

Falling prices in some cases override the income derived from Treasuries and other investment-grade bonds.

A 10-year Treasury yields 2.4 percent, up from 1.5 percent in July. The 30-year yields about 3.1 percent, from 2.2 percent. Both the 10-year and the 30-year have had double-digit price declines since July.

Cash is no longer trash. Roll some Treasury holdings into a money-market fund, given that short-term rates might rise from 0.5 percent to 1 percent, or even 2 percent.

It's a mathematical fact: When interest rates rise, the prices of many bonds drop. Bond yields have almost nowhere to go but up, which would push bond values down.

Where else is a decent safe space for money that might otherwise be in Treasuries?

TIPS. In its latest 2017 outlook, UBS recommends selling Treasuries and instead buying Treasury Inflation Protected Securities.

"Investors shouldn't hold bonds that have a very high probability of delivering negative returns," UBS says. "They should look to switch out longer-duration bonds that are particularly vulnerable to interest-rate rises."

How did we get here?

Because interest rates have been coming down since about 1982, with intermittent increases by the Federal Reserve in some years, a whole generation of investors has become accustomed to bond prices increasing. That's not the case anymore.

And duration is the reason. Here's a warning from the Financial Industry Regulatory Authority Inc. (FINRA):

"Many factors impact bond prices, one of which is interest rates. A maxim of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is known as interest-rate risk. But just as some people's skin is more sensitive to sun than others, some bonds are more sensitive to interest-rate changes. Duration risk is the name economists give to the risk associated with the sensitivity of a bond's price to a 1 percent change in interest rates."

For example, a bond with 10-year duration might decrease in value by 10 percent if interest rates rise 1 percent. If a bond's duration is two years, then a 1 percent rise in interest rates may result in a 2 percent decline in the bond's value.

Although UBS's Top 10 ideas for 2017 include selling Treasuries, the bank added: "We should be clear that we see a sharp sell-off in U.S. Treasury yields in 2017 as unlikely," according to its recent report.

UBS sees increasing growth in the United States, prospects for expansionary fiscal policy, and signs of recovery abroad. But "given the correlation of global interest rates, we do not anticipate a large rise in U.S. Treasury yields as foreign demand remains high."

Instead, "funding TIPS purchases with nominal Treasuries entails lower risk than funding with cash. Purchasing TIPS outright lengthens the duration of an investor's fixed-income portfolio, which may result in negative total returns given their lower yield. Funding TIPS via U.S. Treasuries limits the duration exposure, though unexpectedly aggressive Fed tightening could cause it to underperform."

UBS believes that the best returns from this trade can be achieved with TIPS having a duration between three and seven years.

Stocks and ETFs. In addition, consider stocks like AT&T (yielding 5 percent) or Verizon (4.6 percent yield), or even real estate investment trusts in place of Treasuries.

Or keep your Treasury bond and short the market through ETFs. (This is really only for aggressive investors.) You keep your income flowing and a hedge on bond-price erosion.

ETFs include TBX (short seven- to 10-year Treasuries); PST (short 7- to 10-year U.S. Treasuries, leveraged twice); TBF (short 20-year Treasuries); TBT (short 20-year Treasuries, leveraged twice); IEI (short three- to seven-year Treasuries); TBZ (short 3-7 Treasuries, leveraged twice).

Finally, the VanEck Vectors CEF Municipal Income ETF (XMPT) yields over 5 percent - even after a 0.40 percent expense ratio.