Wading Through the Bond Market Bloodbath

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If you're an investor who has been following a traditional income-style portfolio allocation that includes a lot of U.S. Treasury bonds, then you are likely having a very uncomfortable summer.

Indeed, since the Federal Reserve's "taper" narrative was first introduced to Wall Street by Chairman Ben Bernanke on May 22, there's been a virtual bloodbath in the bond market.

To give you a sense of how much red ink has been spilled in Bondville, let's take a look at the broad measure of the long end of the Treasury bond spectrum, the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT).

Here we see that from May 21 through July 10, the value of TLT plunged 9.6%. A near-10% drop in just seven weeks, in what has traditionally been a safe-haven sector to park capital, is something few market observers expected to see.

If we go up the maturity ladder and look at the damage to the 10-year Treasury note, we see that the closely watched yield on this metric has gone parabolic.

Remember, as bond prices fall bond yields rise, and risen they have. The yield on the benchmark 10-year Treasury note spiked to 2.71% on Friday, July 5. This was the highest level on the 10-year in nearly two years. In percentage terms, the yield on the 10-year note has vaulted an astounding 37.9% from May 21 through July 10.

If this doesn't constitute a bloodbath, then I don't know what does.

Now, as it so often does on Wall Street, selling begets more selling. So it came as no surprise to me that according to TrimTabs Investment Research, in June bond mutual funds and exchange-traded funds lost a record $79.8 billion.

The changing face of the bond market has many income investors feeling a huge degree of uncertainty, angst and even downright fear about what to do next with their money.

And though I'd like to be able to tell you that the bond bloodbath is only temporary, and that what ails bonds will simply heal on its own, the reality is that I can't.

In fact, we are probably in the early stages of a multi-year bear market in bonds.

You see, there's a new paradigm in the income investing world, and this new paradigm requires income investors to be more sophisticated, more proactive, and simply smarter than they've ever been before.

Gone are the days when you can just buy and hold a long-term bond fund such as TLT and get the kind of yield and share price appreciation that you need to generate the total return you've grown accustomed to in recent years.

The fact is that we are entering a period of higher interest rates, lower bond prices, and lower total returns in traditional fixed-income products.

To combat this new reality, you have to realize that you cannot just do what you've always done. You cannot be a passive observer with your income holdings.

Today, you must be willing to embrace unconventional income securities with growth potential, as well as some relatively more aggressive income-generating strategies.

How to Cope With the New Bond Market

One key way I recommend income investors do just this is to embrace dividend-paying growth stocks in their income portfolios.

While stocks always are subject to market risk, they are much less subject to fluctuations in interest rates the way bonds are.

Moreover, the potential upside you have with high-quality, dividend-paying equities are much more than you would have in Treasury bonds.

Although rising rates are generally bad for stocks, interest rates came off such a low base that there is still plenty of room for them to go up before slowing economic growth and corporate earnings.

In fact, most of our dividend stocks made new all-time highs today while bonds and other traditional fixed-income assets continue to languish.

Another technique income investors can employ to help generate additional return on their dividend-paying equity holdings is to write (sell) covered calls on those positions. While this strategy is relatively conservative, it's certainly more aggressive than a traditional buy-and-hold approach to bond funds.

The key element here when investing in dividend-paying equities, and when using covered calls, is that you have plenty of upside in your favor.

To make your income goals a reality, you simply must realign your mindset and be willing to take on a bit more risk in exchange for greater upside. Doing so not only will net you more income, it also will give you a greater sense of control over your money.

And while taking on more risk and having more control over your income portfolio may seem counter-intuitive, it really isn't.

In today's bond market milieu, the rules are very different-and that means what was once considered risky is merely the actions you need to take to be a successful income investor.

Finally, keep in mind that whether the Fed decides to "taper" its bond-buying program at the September FOMC meeting, or whether the committee waits until next year to begin the tapering, the reality is that the bull market in bonds we've enjoyed for nearly 30 years is in its death throes.

If you want your income portfolio to live a full life beyond bonds, then now is the time to embrace the changing paradigm and invest your income-generating capital accordingly.

[Editor's Note: Money Morning welcomes global investing and income expert Robert Hsu to your team of Money Morning investment gurus. Robert is a former hedge fund portfolio manager at Wall Street powerhouse Goldman Sachs, who retired at 31. He since has come out of retirement and founded and is president of money management firm Absolute Return Capital Advisors. But his retirement experience has led to his current mission of helping investors like you achieve their goal of comfortable retirement through profitable income strategies. Money Morning readers will have the opportunity to share in his insights and expertise.]