Tue, Oct 12, 2010, 1:12PM EDT - U.S. Markets close in 2 hrs 48 mins
The biggest thing this past decade should have taught retail investors is to beware when everybody piles into any one asset class. When this happens, the chances are pretty good that a bubble has developed, and recent history shows that sooner or later, bubbles burst.
We've seen it happen with equities, we've seen it in real estate, and now we are about to see the next "bubble bursting sequel" within the bond market. Many U.S. investors have overloaded their retirement and non-retirement portfolios with all kinds of bonds, from treasuries to high-grade corporate bonds to municipal bonds.
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With all of the volatility in the stock market over the past three years, it's no wonder that so many of us have felt more comfortable investing in bonds. We get a more secure interest payment that most of the time offers a much better interest rate than, say, savings accounts.
So where is the downside risk? Quite simply, when interest rates go up, the value of existing bonds goes down because new bonds issued under higher interest rates are naturally more in demand than old bonds paying out under lower interest rates.
The simple fact of the matter is that there isn't any room for interest rates to go in any direction now but up. As the United States and other major world economies continue their road to recovery, the risk of a faster-than-expected increase in interest rates rises because of inflationary pressure that inevitably accompanies economic recovery.
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With all of this in mind, investors can prepare for a new era of higher interest rates and the bursting of the existing bond bubble by educating themselves about shorter-term fixed income investments.
TIPS. Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. The bottom line with TIPS: Investors get fixed interest payments along with the upside, which is protection from inflation.
Low-duration bonds. Assuming interest rates begin to rise--again, a very reasonable assumption given where they are today--the shorter the maturity of your bonds, the less volatility you'll see, because you are not locked into a long-term yield that no longer reflects rising interest rate conditions.
Low-duration bonds may be a good option until rates appear to stabilize. At that time, intermediate maturity bonds (five to 10 years) can be expected to achieve much higher yields. Of course, you will have to give up some yield or interest payments to reduce the volatility.
Higher yielding dividend stocks. When rates go up, that will be a good sign that the economy is on solid footing and is continuing its global recovery. Another way to augment your income is with higher yielding stocks that pay modest dividends. In particular, investors should look for stocks paying a 4 to 6 percent dividend yield as an alternative to sitting back and watching higher interest rates and inflation increases erode the value of their fixed-income portfolios.
Additionally, dividend paying stocks have the potential for both capital appreciation as well as income from dividends. It is incumbent on all investors to have some hedge against the inevitable reappearance of the hidden monster of inflation, and one of the simplest ways to apply this hedge is to purchase dividend paying stocks.
Obviously, no one has a crystal ball that can foresee future financial market developments with total certainty. As with all planning activities, we can go with what past experience has taught us combined with a healthy dollop of common sense.
Investors have a slowly closing window of opportunity to prepare their portfolios for the inevitable bursting of the bond-market bubble.
Doug Lockwood, CFP, is a partner at Harbor Lights Financial Group, a full service wealth-management team that has been dedicated to assisting clients in the accumulation and preservation of their wealth for over eighteen years. He was recently named one of America's Top 100 Financial Advisors byRegistered Rep Magazine (August 2010). Lockwood is a registered representative with and securities offered and advisory services through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC. Diversification does not ensure a profit or guarantee against loss. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
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