Do you own U.S. government Treasury bonds in your portfolio? Millions of Americans do—and that’s a big problem. You see, because the U.S. economy is the largest, and by comparison, most stable government entity in existence, Treasury bonds have been sought after as a place to park money when global markets are in turmoil. Of course, there’s been plenty of turmoil in the global markets over the past five years, and midway through 2013 we saw the first inkling of what could be the next massive bond market meltdown.
In May, the Federal Reserve began dropping hints that it would start pulling back the reins on its unprecedented $85-billion-per-month bond-buying scheme. That caused a mini-panic in the bond market, and the result was a big selloff in long-term Treasury bonds that threw a big scare into those who thought of the bond market as a “safe” place to park assets.
Frighteningly, just the prospect of the biggest buyer of bonds (the Fed) finally pulling back on its purchases, caused long-term bonds to plunge nearly 16% in just five months. In January, that prospect will become reality, as the Fed already has committed to reducing its bond-buying binge by $10 billion per month.
Now I ask you: Can you afford to lose another 15%, 20%, or even 50% or more when interest rates surge and bond values plummet the next time around?
Here are five ways to avoid wiping out your wealth before the next bond meltdown.
The Identification Process
The first step to avoiding a bond market meltdown is to identify when it begins. That’s not the easiest task, but here is one key metric to watch that will telegraph this move: interest rates.
Specifically, interest rates on long-term Treasury bonds such as the benchmark 10-Year Treasury note. These rates, set by the buying and selling of bonds in the secondary market, will begin a sharp rise long before any official action is taken by the Federal Reserve to raise the Fed Funds Rate. On Dec. 26, rates on the 10-year spiked to a new 52-week high of 3%. The breaching of this key level means we could see rates spike even further very, very quickly.
Now, a lot of investors I speak with are under the misconception that it won’t be until the Fed takes action that the bond bubble will begin to burst. This notion is flat-out wrong. You see, the equity and bond markets are forward-looking mechanisms. That means that markets will act in front, and in anticipation of, any official policy action. When the smart money, i.e. the fast money on Wall Street, begins selling bonds, yields will begin to really rise—and that will be your cue that a bond meltdown is heating up.
Determine Exposure to Riskiest Bonds
Once you’ve identified the bond meltdown (ideally before any meltdown takes place), you need to figure out precisely what your level of exposure is to bonds. While this step may sound simple, you would be surprised to find out how many investors hold Treasury bonds in mutual funds, 401(k)s, IRAs, pensions, and other retirement accounts that they really didn’t even know they had.
If you have any kind of an income-oriented mutual fund, or any kind of fund that boasts of having a blend of stocks and bonds, then you likely have more exposure to Treasury bonds and other bonds than you are aware of. The more exposure you find out you have to the riskiest bonds, i.e. those that have the longest-dated maturities, the better equipped you’ll be to make sure you minimize that exposure before the bubble bursts.
After you’ve determined your overall exposure to bonds, you’ll need to move to curtail your exposure to the riskiest, long-dated maturity bonds such as the kind of long-term Treasury bonds found in an exchange-traded fund (ETF) such as the iShares Barclays 20+ Year Treasury Bond (TLT).
The reason: the long end of the yield curve is the most susceptible to interest rate risk. So, if bonds begin to sell, yields will begin to spike and bond prices will begin to fall—and the biggest damage will occur in long-term, 20-plus year Treasury bonds. Similar pain also is likely in 10-year Treasury notes, which are widely held by many investors, and many bond mutual funds as well as many growth and income funds.
By reducing duration in your bond holdings, you’ll be in a much better position to prevail during the next bond market meltdown.
Hedge Your Bets
If bond values start to melt down again as I suspect they will, one way to take advantage of that trend is to own investments designed to do well when bond prices falter. Two ways to do this are with ETFs such as the ProShares Short 20+ Year Treasury ETF (TBF), and its more aggressive and leveraged big brother, the ProShares UltraShort 20+ Year Treasury ETF (TBT).
Both of these funds are designed to deliver the inverse price performance of the 20+ year Treasury bond segment, but with TBF it’s a one-for-one proposition. TBT employs leverage, and as such it’s designed to move twice the inverse of Treasury bond prices. As you can see by the price charts here of TBF and TBT, both funds surged dramatically from May through September, as smart investors rotated money into these funds as bonds were being sold off.
These hedged positions are a great way for either more conservative investors (TBF), or more aggressive traders (TBT) to take advantage of periods where bonds are out of favor—and these funds will really give your portfolio an edge during the next bond market meltdown.
Diversify with Dividend Stocks
If you own bonds, you are likely in the market for income. Yet during a bond market meltdown, you’re going to be losing principal, and that’s going to take a big whack out of your overall wealth. To avoid this, you’ll want to own other asset classes, and one of the best asset classes to own is stable dividend-paying stocks.
Here we are talking about well-known names, well-capitalized and cash-rich companies with a competitive advantage in their respective sector, and companies that make the kinds of products that will continue to sell no matter what the conditions are in the global economy.
These would be the corporate giants that pay solid dividends, and that have a track record of paying and increasing dividends each year. These are the companies that also pay an attractive dividend yield, usually in the 3% to 5% range. These companies also stand to profit from a flight-to-quality away from Treasurys and into stocks once the bond meltdown takes place.
An exchange traded fund that fits this bill is the iShares DJ Select Dividend Index Fund (DVY). This fund holds the biggest and best dividend-paying stocks in the market today. Shares of DVY performed beautifully in 2013, with a total return of nearly 25%. Once bonds begin the inevitable, i.e. their next big meltdown, look for capital to flee and find its way into the likes of DVY—and then just relax and collect your profits.