By Adam Fischbaum
Whenever financial markets start to sell off, I can't help but remember the scene from "Trading Places" (perhaps the greatest investment business movie of all time) when Eddie Murphy discusses pork-belly trading strategy with stodgy commodities brokers Ralph Belamy and Don Ameche. Murphy's streetwise character -- Billy Ray Valentine -- explains why pork-belly prices are softening. He finishes his soliloquy with an emphatic "They're panicking... they're screaming sell! Sell! "
I have a feeling I will be hearing Billy Ray's words soon. But this time it'll be about the bond market. And unfortunately, I don't think the scene will be as funny.
Let me explain...
The other day, the Columbia Strategic Income Fund (MUTF:COSIX) was brought to my attention. I don't dabble much with mutual funds, but something compelled me to drill down into this bond fund. It's probably because it's been around since 1977, and the bond market has done a lot since my dad used to dress like Mike Brady.
But when I looked at the 10-year chart of this fund, there was no laugh track.
If you've owned this fund, then you've done well. There's no question about that. The issue is that this chart is also, to my mind, the single-best indication of where the bond market is going next.
You can see exactly when former Federal Reserve Chairman Alan Greenspan turned on the post 9/11 American credit spigot, flooding all sorts of markets with cheap funds. You can also see when the music stopped in 2008, freezing the credit markets only to have them de-iced with quantitative easing, through "QEI," "QEII," as well as "Operation Twist."
And judging by the wiggles on the chart, it looks like the party is just about over.
Sell when you can... not when you have to
More often than not, individual investors wait too late to get out and wind up selling at the lower point of a downturn instead of when the getting was good.
And right now may be the best opportunity to sell your bonds or bond funds.
Historically, individual investors have been hesitant to sell this asset class. But bonds behave like stocks, gold or any other commodity. And when an asset class goes up in price, it's perfectly fine to take profits -- especially when there's no more room for it to grow.
Should you get rid of all of your fixed-income facing investments? Not necessarily.
Let's say your basic asset allocation is 60% stocks and 40% bonds. In this case, it would be wise to bring your bond allocation back to around 30% or 35% before things start to get ugly. If conditions deteriorate significantly, then you should trim your allocation down to 25% or 20%.
This is a smart way to play defense, especially because in doing this, you'll have cash available in case the market presents new investment opportunities.
Here are three ideas of what you could do...
1. Dividend-paying common stocks
Dividend-paying stocks are in vogue, though I never knew that they had gone out of style.
Great companies with great businesses, great cash flow and solid dividend histories can provide even steadier income than bonds -- especially these days. The current challenge is finding high-quality stocks with respectable yields trading at low prices, since many well-known dividend stocks have been bid up to recent highs. AT&T (NYSE: T), for instance, is still an OK candidate near $32 a share, a forward price-to-earnings (P/E) ratio of about 13.5 and a 5.5% dividend yield. But the stock is flirting with its 52-week high, so I wouldn't load the boats with this stock at first. Buying a half position and only buying more on a pullback would be the best strategy in this case.
Utility stocks are good dividend-paying investments. Although they look a little stretched out (the Dow Jones Utility Average returned nearly 15% before dividends last year -- throw those in and we're probably closer to 19%), stocks like Exelon Corp. (NYSE: EXC) still offer some value. Trading at a bit of a discount to its peers, with a forward P/E of less than 13 and a 5% yield, shares can be picked up at around at a nice 13% discount to their 52-week high.
2. Real-estate investment trusts (REITS)
REITs can provide income and diversification. After the top of just about all (commercial and residential) real-estate markets in 2006, most stocks cratered. Five years later, some of the more widely held REITS, such as Simon Property Group (NYSE: SPG) or Public Storage (NYSE: PSA), have not only recovered from their 2008-2009 lows -- but they're trading near all-time highs.
I particularly like the CBRE Clarion Global Real Estate Income Fund (NYSE: IGR). This is a globally-focused, closed-end REIT fund. At about $8 a share and yielding almost 7%, the fund trades at roughly 9% discount to its net asset value (NAV). That's not a bad way to own a diverse asset class and get decent income.
OK, before you hunt me down and begin pelting me with rocks and garbage... I realize cash pays absolutely nothing. But traditionally, investors add bonds to their portfolios for income and volatility protection.
Cash can have the same effect.
If bonds became volatile, which could eventually happen, then investors would see their investments go up and down in tandem with the market.
I know cash is a lousy asset these days. But if your goal is to preserve capital and manage volatility, then you probably won't be able to accomplish it with the bond portion of your portfolio alone.
Risk to Consider: With as much uncertainty as there is out there, it's highly possible that I am the proverbial boy crying wolf. After all, bonds have always served as a safe haven for investors. In addition, the Federal Reserve remains firmly committed to the zero interest rate policy for the next two years. This could still support fixed-income asset prices and keep the bond market hot for a couple more years.
On the other hand, the yields from the alternatives I discussed above can help compensate investors for acting too soon. It's better to be safe than sorry. Taking profits in an asset class is a natural, disciplined part of a sound investment strategy.
Investors who have owned bonds have done well, but it's time to play a little defense. Given the bad signs I'm seeing in the bond market, investors should consider the other viable investments I mentioned above.