Coauthored by Kristina Maestas

The following is a recap of how Portfolio, LLC, will be approaching interest rates, duration, and credit risk in 2011. It is important for you to understand bond duration, the effect of catastrophic market events on treasuries, and a basic way to hedge bond risk without taking dramatic moves.

The Most Significant Threat in 2011: TLT. LQD. CIU and BND

For the upcoming year, we are making a few strategic investment changes that will continue to sustain and enhance our clients financial objectives. Its not enough to simply manage risk on the short to intermediate time frame. Seeking a profitable fundamental worldview over longer periods of time is still necessary. Portfolio seeks to protect clients assets, even at the most volatile times in the economy. The year 2011 will be no different. The most significant threat we see in 2011: rising interest rates.

We live in an incredible time when investors have the case study of the 2008 financial crisis. It is rare that we have the perspective of a recent catastrophe to help guide us going forward. In an attempt to boost a speedy economic recovery, the Federal Reserve embraced an easy monetary policy, moving interest rates to historically low levels. Savvy investors immediately flocked to the most desirable assets in the market, long-term treasury bonds. Long-term treasury bonds offer three fundamentally appealing components during times of catastrophic market conditions: long bond duration, unsurpassed security, and the ultimate in liquidity.

In order to understand why we care about bonds, it is necessary to understand a concept called duration. A bonds duration indicates the volatility of its price to changes in interest rates. Stay with us, this is easier than you think! For example, a bond with a duration of seven years, is expected to increase 7% in value for every 1% decrease in interest rates, and vice versa. Take a tradable basket of treasury bonds like the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT ). It reached its peak value at the height of the financial collapse in 2008. With a bond duration of 15.5 years, TLT rewarded its investors with a positive return of 34%, as interest rates plummeted through 2008. That return was based on three things. Rates went down, so the value of the bonds whet up. A 1% decline in rates pretty much meant a 15+% increase in value. Second, the bonds were liquid, since everyone trades treasuries. Third, despite all of our criticism about the US government, the world still sees US Treasuries as the safest investment. All that means is that we assume US Treasuries will be the last thing to go bust.

The variation in performance between TLT and other longer duration bond ETFs such as iShares ibex $ Invest Grade Corp Bond (NYSEARCA:LQD ), lies in the perceived security of the bond. What we are talking about is why some bonds do better than others given different market conditions. Nobody prices in credit risk for treasuries, making them a pure interest rate investment. While treasury bonds are priced solely on interest rates, corporate bonds have another derivative to consider: earnings risk. In 2008, investor speculation regarding the inability of corporations to pay their bonds put downward pressure on the price of corporate bonds. Consequentially, LQD, with a moderately high duration of 7.4 years, did not experience increases in its value as market rates decreased. This was because any gains made in lower interest rates were offset by investors freaking out about the potential default of those corporate bonds. See how this is not as hard as it first appears?

History will show that in times of catastrophic economic collapse and decreasing interest rates, longer duration government bond exposure is attractive. However, higher duration bonds are commensurate with volatility; should interest rates rise, the value of existing bonds in a given portfolio will simultaneously decrease. At present, the global currency wars designed to stimulate economic growth between competing economies (i.e. East vs. West vs. Europe) is synonymous with rising interest rates. For the year 2011, we expect to see bond prices decline with the gradual or quick rise in rates.

A truly diversified asset portfolio will always have some exposure to bonds, regardless of that portfolios risk. You cant assume that just because we think rates will rise that they will, or that they will do so in the time frame we suggest. This is a fancy way of saying we can be wrong. Rather than changing your asset allocation, risk, and financial goals, it is more appropriate to shorten the duration of your bond exposure. We currently use four ETFs to manage our bond allocation: iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY ), Vanguard Total Bond Market ETF (NYSEARCA:BND ), LQD, and TLT. These ETFs have bond durations of 1.9, 4.8, 7.4, and 15.5 years respectively. Because of TLTs long duration, it risks significant decreases in value with small increases in interest rates. Our first strategic move for 2011 will be dumping TLT.

Next, we will be replacing LQD with iShares Barclays Intermediate Credit Bond Fund (NYSEARCA:CIU ). CIU has a duration of 4.3 years and an annual yield of 4.15%. As LQD has a yield of 4.84%, we will retain 86% of the yield but reduce our risk exposure by 42%. Additionally, both investment vehicles have the same credit quality keeping clients credit risk the same. This ultimately leaves our bond allocation to three ETFs: SHY, BND, and CIU. These ETFs will encompass a healthy mix of short-term treasuries and corporate bonds. These are common sense solutions that will minimize our clients risk while maximizing comparable bond quality and yield.

Protecting the wealth entrusted to us is our number one priority. As we predict interest rate increases in the future, the solution to our asset allocation is simple: shorten the duration of bond exposure. Ultimately by removing TLT and replacing LQD with CIU, we are able to fundamentally keep the asset allocation of our clients stable. Tactically, we are hedging risk, giving up a small percentage of annual return but reducing duration risk by 42%. In sum, this means that should our prediction of interest rates be flawed, meaning they remain stagnant or decrease, we will still make our clients money, offer them comparable annual cash flow, and ultimately protect their wealth in the long-term.

Disclosure: Author long TLT, LQD, CIU and BND