Wall Street Worries? Protect Your Money Now

When investors soured on stocks in 2008, they started piling into bonds. The combination of huge demand, rate cutting by the Federal Reserve and a slow economy drove interest rates down to historic levels, and bond investors got stellar returns. (Bond prices rise when interest rates fall because the older, higher-yielding bonds become more valuable.) Now it seems as if there’s nowhere for interest rates to go but up, and that’s bad news for bonds, since the price of old (lower-yielding) bonds will fall as market rates rise. Indeed, the air already seems to be leaking out of the balloon — the price of a 10-year Treasury that matures in November 2020 has dropped 6 percent in just the past two months.

• Strategy: Go short. The longer the maturity on the bond, the more it’s affected by rising rates. If you stick with bonds that mature within five to seven years, rising rates will only nick your portfolio by about half as much as they would if you were holding 30-year bonds. For example, rates on 10-year Treasuries jumped 1.3 percentage points in early 2009. What happened to bond prices? The Barclays 5-10 year Treasury index lost 4.8 percent; the Barclays Long Treasury index fell nearly 13 percent.
  

  One simple way to invest in medium to short-term bonds is to buy a mutual fund such as Vanguard’s Intermediate Term U.S. Treasury fund (VFITX), which invests solely in U.S. Treasuries with an average maturity of 5 to 10 years. If you want a touch more yield, you can buy Vanguard’s Intermediate Term bond index fund (VBIIX), which invests in high-grade corporate and government securities that mature in less than 10 years. Or stay even shorter with the Vanguard Short-Term Investment Grade fund (VFSTX).

• Price: Risk and reward go hand-in-hand, so the shorter the maturity, the less the return. A 5-year Treasury bill, for example, was recently yielding 2 percent, while 30-year bonds were paying 4.41 percent.

One scenario that would blow a hole in the bond bubble: a significant spike in inflation. Indeed, many experts are convinced that today’s benign price growth and low interest rates can’t last. If inflation soars, so do interest rates and that spells disaster for your bond portfolio. If long term interest rates were to shoot higher by 5 percentage points, the value of a traditional bond portfolio would plunge 50 percent, says Paul Jacobs, a certified financial planner at Palisades Hudson Financial Group in Scarsdale, NY.

• Strategy: Add commodities and floating-rate securities to your portfolio. Floating-rate bond funds, such as the Fidelity Floating Rate High-Yield Fund (FFRHX), offer rising yields when market rates rise. A fund or exchange-traded note that tracks a commodities index, such as the Dow Jones-UBS Commodity ETN (DJP), should also increase in value when inflation rises. In the past if you were worried about inflation, experts also advised buying the U.S. Treasury’s Inflation Protection Securities, better known as TIPS. In addition to giving investors a (small) yield, TIPS keep up with inflation because your principal increases each year by the amount of the consumer price index. But the prospect of inflation is so baked into the market psyche that TIPS yields actually went negative in October, and have been bumping around zero ever since. A TIPS fund, however, such as Vanguard’s Inflation-Protected Securities Fund (VIPSX), which yields a sorry 0.38 percent today can continue buying the bonds as yields move higher.
• Price: Floating-rate bond funds typically invest in the debt of highly-leveraged companies, so there’s some risk of default in that portfolio — especially if rates rise enough to push those companies into bankruptcy. Also, commodity prices are notoriously volatile, so dedicating more than a small amount of your portfolio to commodities creates a whole new risk.

If you want to see a real horror story, take a look at the performance of Japan’s Nikkei index, which topped out near 39,000 in late 1989 and has been slipping ever since — today it hovers around 10,500. Japanese stock prices are now at roughly the same level they were in 1983. The culprit is deflation — declining prices that cause consumers to sit on their pocketbooks, depressing prices of everything. Why buy something today when it will be cheaper next month?

• Strategy: Cash is king in a deflationary environment, says Linda Robertson, senior financial planner with Financial Finesse in Manhattan Beach, Calif. Even though you’re not likely to earn much interest on your money when it’s invested in bank deposits and short-term Treasury bills, having money stashed in cash benefits you because prices decline with each passing day. In a deflationary environment, a portfolio that doesn’t grow at all still increases your buying power. Right now there’s an unusual anomaly in the market, however, that allows you to get a decent yield by owning long-term bank CDs with limited early withdrawal penalties. As MoneyWatch blogger Allan Roth has explained, you can earn yields in the range of 2.7 percent, and if you decide to withdraw the money early, pay a penalty of only two months’ interest.
• Price: If deflation doesn’t materialize, the cash in your portfolio is going to slowly lose buying power. Your cost is that loss of buying power plus the “opportunity cost” of not having your money in higher-yielding investments. On the other hand, the high-yield CDs mentioned above will keep you ahead of inflation, and since you can sell without paying much of a penalty and move your cash into higher yielding options, the price of this protection is relatively low. Consider this part of your fixed income portfolio.

You know you need to have exposure to the stock market, but you can’t stomach the idea of holding an asset that could lose nearly half its value in six months, as stocks did from September 2008 to March 2009.

• Strategy: The best protection against a market crash is to have a portfolio that’s well-diversified between stocks and bonds, and to rebalance it regularly — this strategy would have resulted in minimal losses even from the 2008 disaster. But there may be cases where you want a more targeted insurance policy — for instance if you own stocks options or restricted stock that you can’t sell. You can hedge against losses by buying “puts” on the security. You can even buy puts on an entire index, such as the S&P 500. Puts give you the right to sell shares at a specific price in the future. So, for instance, you could buy puts that give you the right to sell at a price that’s 10 percent below today’s price. You wouldn’t exercise your puts if the security drops less than that, but if it drops more, you can sell at your strike price and pocket the difference.
• Price: A put on the S&P 500 that would allow you to sell 100 shares at an 1,100-point level (the index is at about 1280 now) in 90 days recently cost between $690 and $890. A typical option contract (“puts” are options to sell; “calls” are options to buy) expires in three months. If you want protection that lasts longer, it costs more. Never bought or sold options and don’t know how they work? The Chicago Board Options Exchange offers free tutorials on its Web site. Keep in mind that this is a very pricey strategy. Renew that option every three months, and you’re spending around $3,000 a year on an index that, recent history notwithstanding, tends to rise more than fall.

You can’t name the disaster. You don’t know exactly what it is, how powerful it might be or when it might strike. But you’re pretty sure there’s a huge risk lurking in the financial markets somewhere and it’s dangerous and frightening. The biggest danger is that your fear will lead you to do exactly the wrong thing, such as selling at the bottom or buying “safe” bonds at their peak.

• Strategy: Diversify — widely. Because different markets rise and fall at different times, the only way to protect your portfolio from the disaster-that-cannot-be-named is to divvy your assets up among many different types of investments, including stocks, bonds, cash, commodities, and real estate, says Jerry Miccolis, chief investment officer at Brinton Eaton, a boutique investment firm in Madison, N.J.

  But the 2008 market rout that savaged virtually all markets in 2008 led some to believe that traditional diversification is not enough. Investors need some assets in emerging stock markets in Asia and South America; commodities such as timber (not just gold); and investments in commercial real estate, which you can buy through Real Estate Investment Trusts and real estate-focused mutual funds. Of course, even those asset classes declined in 2008, but at least Treasuries and gold held up. And some asset classes bounced back faster than others. Miccolis also likes exchange-traded funds that bet on market volatility by mimicking volatility indexes, such as Deutsche Bank’s EMERALD index, which aims to capture the variance in S&P 500 prices.

• Price: When you’re widely diversified, there’s a good chance that some part of your portfolio is always going to be performing badly. On the other hand, some investments also should be performing well at all times, which reduces the chances that a market disaster will savage your financial future. And by rebalancing — selling winners and buying more of the losers — you are automatically buying low and selling high.

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• Best Bond Strategy Now
• Mutual Fund Picks: 8 Best Index Funds