The Federal Reserve’s December 18 decision to taper its quantitative easing policy by $10 billion per month is undoubtedly old news. Even the January 29 decision to continue the taper has already been priced into the market. And now that we’ve finally gotten to see the January meeting minutes, it has become clear that the Federal Reserve has no intention of stopping the taper, unless economic indicators change materially.

While headlines surrounding the taper have been known to wreak havoc on the markets, the continuation of the taper is an indicator that the Federal Reserve is confident about the state of the U.S. economy. Recently-appointed Fed Chairwoman Janet Yellen is also supposedly planning on providing forward guidance on future Fed actions. Although positive over the long term, this guidance may pose the threat of headline risk in the short term. Currently, the expectation is that there will be a steady reduction in the purchase of bonds and that interest rates will continue to stay low for the foreseeable future. I would also argue that Yellen shows signs of focusing on the unemployment aspects of the Federal Reserve mandate, so odds are good that the Fed Funds rate won’t be increased until unemployment is much lower than the current 6.5 percent benchmark.

Given these facts, it would seem that bond holders have little to worry about. Unfortunately, quantitative easing may ultimately prove to be problematic for long-term interest rates, posing serious issues for many investors. Even if the taper has no material impact on short-term interest rates, it does have the potential to make investors nervous about their fixed-income portfolio. Fortunately, there are ways to manage this Great Fed Unwinding.

Consider Diversifying Your Bond Holdings
Many investors hold fixed-income securities for a specific reason: When you really need bonds, there aren’t many substitutes. However, with the concern over rates rising, it makes sense to consider managing interest rate risk.  I can think of a number of ways to hedge interest rate risk, from classic trades like shorting bonds to more sophisticated strategies such as swaps. For the average investor, however, diversification can be a pretty good way to manage risk, with the potential for less complication and much lower fees.

Given the current investing environment, an investor could consider adding high-yield bonds. Corporate balance sheets are  fairly strong and at this point in the credit cycle the risk of default seems relatively low. In addition, the higher coupons might  mitigate some of the interest rate risk. Of course, it’s not advisable to only hold high-yield bonds—a mixture of fixed-income securities could serve as a good start towards diversifying the risk profile of your portfolio.

Consider Hedged Equity
Another hedging strategy is to increase allocations in asset classes with a similar investment objective as bonds, but without the interest rate risk. Investors looking to reduce some of their interest rate risk through alternative asset allocations might want to consider hedged equity. Hedged equity generally involves purchasing an underlying equity security and hedging that position with option strategies. Because the underlying security is an equity, it doesn’t necessarily “hedge” interest rate risk.  However, because you have substituted one type of risk for another, or diversified your risk, it can improve the risk-return profile of your holdings.

Let’s suppose you’re an investor who holds bonds to generate a 3 percent to 5 percent return with minimal risk and volatility. In this case, you could either diversify those bond holdings with the strategies discussed above or diversify that particular risk-return profile. In other words, you could look for some other type of strategy or asset class that generates a 3 percent to  5 percent return with relatively low volatility and no interest rate risk.

Some hedged equity strategies strive to achieve this risk-return profile, but since these strategies can vary greatly, make sure you do your research. Either way, they may be an excellent source of risk diversification.

Think Outside The Box
These two strategies may be personal favorites of mine, but there are many other ways to protect your portfolio and minimize risk. No matter how you decide to hedge your fixed-income portfolio, it’s important to reevaluate frequently and consider how the conditions have changed since your last adjustment.

George Hashbarger Jr. is a portfolio manager with BPV Family of Funds and founding partner and president of Quintium Advisor. Hashbarger has 29 years of experience in investing and financial services with expertise in equity investment, option strategies and tactical fund allocations.