The markets rebounded Tuesday from the worst week of the year but the pain may be yet to come. Historically, September is the worst month for investors with an average monthly loss of 0.69% and October has posted the worst two monthly returns going back to 1950. With bonds not providing their historic role as safety, investors looking to protect their portfolios need to look to other sectors like master limited partnerships (MLPs), real estate investment trusts (REITs), bank loans, emerging markets and high yield bonds.
End of the Party for Bonds and Stock Bulls Alike
The drama over the debt ceiling is just beginning to come to the markets and could hit stocks like they did in 2011, sending the S&P500 plummeting 17% in less than three weeks. If that were not bad enough, we still have to contend with volatility around the Fed's tapering of $85 billion in monthly bond purchases that most believe will begin in September. While I recently argued that tapering and the volatility around the Fed did not really matter and outlined five investments to take advantage of short-term volatility, there is still a considerable amount of event risk that risk-averse investors may want to hedge.
For the past 30 years, the standard response would be to seek capital safety by putting more of your portfolio in corporate or treasury bonds. Over the year to the market bottom in March 2009, the S&P500 lost 40% after adjusting for dividends versus a gain of 19% for the iShares Core U.S. Bond Market (NYSEARCA:AGG).
This historic tradeoff looks to have broken down with surging rates and investors looking to hedge near-term uncertainty with bonds may be in for large losses. While the S&P500 has lost nearly 2.5% over the last month, the aggregate bond fund is down almost 2% and shares of the SPDR Barclays Capital Long Corporate Bond Fund (NYSEARCA:LWC) have lost more than 5%.
Even after surging past 2.8% on Monday, rates are still at historic lows and most believe they have further to rise. The median estimate for rates on the 10-year treasury is 3.25% by the end of 2014. Bonds with shorter durations may not fall as quickly but will not offer much yield while higher-yielding long bonds will fall faster with the change in rates.
Income and Safety from Non-Traditional Plays
Even if the Federal Reserve holds off on tapering the $85 billion in monthly purchases or takes longer to unwind the program than the market anticipates, rates are set to rise and investors need to look to other sectors to provide the kind of capital preservation and income that has historically come from bonds.
Master Limited Partnerships are similar to REITs in that corporate taxes are avoided if most income is paid out to shareholders. These partnerships are typically companies holding oil and gas assets like pipelines and storage facilities. Revenue is usually based on the volume transported so the companies are not as dependent on energy prices, just overall demand.
The ALPS Alerian MLP ETF (NYSEARCA:AMLP) pays a 5.8% dividend yield and holds shares in 25 partnerships. The boom in energy extraction in the United States means infrastructure will have to be built out for years to come and these companies should be able to increase payouts. By investing in the fund, investors avoid filling out a K-1 tax schedule which is normally required when investing in individual companies. The fund lost less than a percent in the selloff last week and is up 13% over the last year.
Real Estate Investment Trusts have gotten a bad name since the meltdown in residential properties but the fact is that these companies are backed by real assets that should hold their value relatively well when the rest of the market crashes. The NAREIT index of equity REITs has returned an annualized 12% since 1971 versus an annual return of just 7% for stocks in the S&P500.
The Vanguard REIT Index (NYSEARCA:VNQ) invests in 125 companies and pays a 3.6% yield. Specialized and retail REITs make up more than half (57%) of holdings followed by residential (17%), office (13%), industrial (5%) and diversified REITs (8%). The fund underperformed with a 6% loss last week but is up 4% over the last year, easily outperforming long-term corporate bonds.
Bank loan funds are becoming more popular as investors look to safety outside of traditional bonds. The funds normally invest in floating-rate loans so prices are not as exposed to rising rates as fixed-rate bonds. Typically, they also offer a higher yield than similar term bonds because of higher credit risk.
The PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) is designed to track the performance of large institutional leveraged loan portfolios based on market weightings, spreads and payments. The shares pay a 4.6% yield and almost half (47%) of holdings are rated BB or better by Standard & Poor's. The fund lost less than a percent (0.56%) last week and is up 5.3% over the last year.
Emerging Market Bonds have been hit hard lately as investors fear Fed tapering will lead to a liquidity crisis in emerging markets. While select countries like India and Brazil are seeing their currencies hit particularly hard, the fundamentals in the EM space are much stronger than they have been in the past. The bonds issued by these governments and the higher-rated companies should be fairly safe and will outperform domestic alternatives.
The WisdomTree Emerging Markets Corporate Bond (NASDAQ:EMCB) is a newer option for investors and invests in 36 bonds issued by corporations domiciled in emerging markets. Almost two-thirds of holdings (65.7%) are rated BBB or better by Standard and Poor's and the assets have an effective duration of 5.7 years, slightly below that of most bond funds. The fund pays a 4.5% yield and has a large exposure, 51% of assets, to Latin American corporations. The fund lost just a third of a percent last week but is down 1.4% over the last year.
High Yield bonds may be preferable to investment grade alternatives because the bonds are partly priced on the financial health of the issuer as well as on rates. This means that when rates rise in a recovering economy, bond prices may not fall as fast due to credit upgrades. Because of the increased credit risk, the bonds pay a higher-yield than bonds with better ratings.
The SPDR Barclays Capital Short Term High Yield Bond (NYSEARCA:SJNK) pays a 6.3% yield and will not have nearly as much rate risk because of its shorter duration. The fund holds 388 bonds with an average duration of just 3.5 years. Only 1.3% of the bonds are rated BBB or higher with 15.8% of holdings rated CCC or lower by Standard and Poor's. The fund lost less than a fifth of a percent last week and is up 6.5% over the last year.
Safety Always has a Cost
If you are looking for investments that will always outperform stocks in an up or down market, you will probably be disappointed. Investments that beat a pure equity position are rare and they usually will not outperform over the long-term. The idea with the 'safety' portion of your portfolio, that portion normally reserved to bonds, is to protect capital while providing a modest income when stocks take a nosedive. With the secular outlook on rates, domestic bonds might not be able to fulfill this need for quite a few years and investors need to start thinking about non-traditional safety plays. While the stocks listed above have not outperformed the general market over the last year, they have all outperformed the Barclays Long-term Corporate Bond Index by more than 7.5% over the last year.
Disclosure: I am long BKLN, EMCB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.