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An Overlooked Way to Protect Your Fixed-Income Investments Could Return Up to 180%

In May, the interest rate on the 10-year Treasury note rose from about 1.6% to more than 2.2%. As rates rise, bond prices fall, and an ETF that tracks Treasury notes, iShares Barclays 7-10 Year Treasury (NYSE: IEF), dropped 3.1% in May.

Since then, rates have fallen back toward 2%. Fixed-income investors must now decide whether they expect rates to continue moving higher.

Many investors hold fixed-income investments to lower portfolio volatility and provide steady income. A popular strategy is to invest 60% of a portfolio in stocks and 40% in bonds. If rates rise, the bond holdings could suffer large losses and investors may lose principal that is equal to several years' worth of income.

After a sharp move in the market leads to losses, some investors consider selling. In this case, those investors may be thinking they should sell their bond funds and reinvest later at higher rates. Of course, if rates don't rise, they will suffer a loss of income but have no benefit from the trade.

But there are other options available. Conservative investors use covered calls and other option strategies to protect their investments in the stock market. Similar strategies are available in the bond markets but are often overlooked.

If you own bond ETFs, now is an excellent time to sell options on them. Their recent losses have led to an increase in volatility for those funds, and options prices tend to rise along with volatility.

Covered calls are one way to protect an investment in bond ETFs. With a covered call, you sell a call option on a stock that you own. Each options contract covers 100 shares of a stock or ETF. For IEF, for example, you could sell a call expiring in December with an exercise price of $108 for about $0.53.

Since each contract covers 100 shares of stock, the immediate income from selling the option will be $53. While you own the stock, you will collect the monthly dividend that IEF pays. That dividend varies each month. In June it was $0.142 per share. To be conservative, we will assume that it is $0.12 a month since it has been above that amount every month for the past year.

The option expires in December, more than six months from now. The dividend income of at least $0.72 would add to the profits already generated by selling the call.

If IEF is above $108 when the call expires, you will have to sell the ETF at that price. With IEF trading at about $104.89 now, that is a potential profit of $3.11 per share. Total profits on this trade would add up to $4.36 per share ($0.53 from selling the call + $3.11 in capital gains + $0.72 in dividends), or 4.15% in six months. This represents an annualized profit of more than 8% from bonds.

If IEF is below $108 when the option expires, you will keep the shares and the income from selling the call and dividends. In this case, your income is almost double what it would have been with a simple buy-and-hold strategy.

Recommended Trade Setup:

-- Sell one IEF Dec 108 Call at the market price for each 100 shares of IEF you own
-- Do not use a stop-loss

A covered call is an excellent trade for cushioning potential losses in bonds while increasing income. For more aggressive traders, buying a put option may be a way to profit from a decline in bonds.

If interest rates rise 1%, IEF should be expected to fall about 7.6% for a price target of $96.93. A put option can be used to profit from declines.

When a trader buys a put, they have the right to sell 100 shares of the stock or ETF at a predetermined price for a certain amount of time. A December put with an exercise price of $105 on IEF could be bought for about $2.88. If IEF falls to $96.93, this put would be worth at least $8.07, a potential profit of 180%. You would not have to sell IEF to take the profit. You can also close this trade by selling the put in the same way you sell a stock that you own.

If interest rates rise less than 1%, IEF would show a smaller loss and the puts would show a smaller gain. If IEF is trading above $105 when the option expires in December, they would be worthless. The maximum loss is limited to the amount paid to buy the put.

Buying a put is another way to insure a fixed-income strategy against losses.

Recommended Trade Setup:

-- Buy IEF Dec 105 Puts at $3 or less
-- Do not use a stop-loss; the risk is limited to the amount paid for the option
-- If interest rates fall 1%, this option could be worth $8.07 and deliver a potential profit of 169%