Highlights

• Interest rates are falling faster than a drunken tight-rope walker.
• There is considerable disagreement amongst market commentators and portfolio managers on how to respond.
• There are various ways to lower your vulnerability to a bear market.

“The Sky is falling” is the catch phrase of Henny Penny (more commonly referred to as “Chicken Little” here in the U.S.), the lead character in a European folk tale of a chicken who goes on a quest to warn others that the world is coming to an end after getting hit in the head by an acorn. The moral of the story: Don’t believe everything you hear.

Last week, market procrastinators were issuing warnings that a recession is looming and the long-lasting bull market is coming to an end. The motivation for their proclamations is the inversion of the yield curve, which graphically depicts the interest-rate spread between short- and long-term bonds. 

More specifically, on August 14^th the interest rate paid on 2-year bonds rose above that paid on 10-year bonds. The same condition has occurred prior to each of the last nine U.S. economic recessions, according to the San Francisco Federal Reserve Bank.

Nonetheless, as Jim Picerno, The Milwaukee Company’s Director of Analytics, explains here (and as we will be discussing in more detail in our Diversify and Conquer post tomorrow), in my view, an inverted yield curve should not be looked at as a prediction that a recession is forthcoming. To the contrary, it should be regarded as a signal that the likelihood of a recession is high, ifpolicymakers do not implement preventative measures in response.

One thing is sure: interest rates have been falling faster than a drunken tight-rope walker. At the end of trading on August 16^th, the interest rate on a 30-year Treasury stood at just 1.98%, while the 10-year rate settled at 1.54%. Former Federal Reserve Chairman Alan Greenspan has gone on record saying that he won’t be surprised if U.S. bond yields turn negative. Things have gotten so wacky that a bank in Denmark is willing to pay borrowers to take out a mortgage (Sign me up!).

There is little precedent for what’s currently happening in the bond market. As a result, the disagreement on what investors should do in response to plummeting rates has triggered even more disagreement than usual. Much like Chicken Little, some market pundits are predicting the sky is falling, and recommending investors run (not walk) for the exits. Others are advising the recent sell-off has created a buying opportunity.

In my view, the correct response probably can be found somewhere in the middle. Here are some measured ways you might tactically adapt your portfolio to falling interest rates.

1. Adopt a more defensive asset allocation.

• Pros: Your portfolio will be less vulnerable to a bear market.
• Cons: Typically, lower risk means lower returns over the long run. Repositioning the portfolio could also trigger capital gain taxes. Moreover, if the markets continue to trend upwards, there could be a serious risk of a whipsaw.

2. Lower allocations to low-yielding government debt in favor of higher-yielding, lower-grade corporate debt, or convertibles.

• Pros: You will recover some of the interest income you lost as a result of falling rates. Price appreciation in convertible bonds can also help improve portfolio returns.
• Cons: You will have added the risk of default to your things to worry about. That risk will only increase if economic conditions deteriorate.

3. Re-allocate a portion of your bonds to strong dividend-paying stocks or preferred stocks.

• Pros: The proliferation of dividend-focused ETFs makes this an easy way to up the income generated by your portfolio. It also would create the potential to enjoy capital appreciation should this asset class continue its rally.

• Cons: You may be late to the party. High dividend and preferred stocks are already up approximately 9.05% and 13.08% respectively so far this year. In addition, high-yield stocks tend to move inversely to interest rates. This could prove to be a dangerous combination should interest rates reverse course.  In other words, you could be trading one risk for another.

4. Add real estate investment trust (REIT) ETFs to your portfolio (or increase the amount you have invested in REITs). REITS are essentially pools of investor capital that is invested in income producing real estate projects.

• Pros: REITs are another source for higher yields, and are generally regarded as a safer asset class than junk bonds. They also may provide you with a greater diversification benefit than dividend stocks.
• Cons: REITs have been the strongest major asset class this year, so they too could be in line for a significant correction should interest rates reverse course. REITs also suffered badly in the Great Recession of 2008-2009 and could do so again if the economy tanks.

5. Purchase put option contracts on a broad market index such as the S&P 500 to hedge against a stock market crash. As discussed in a previous post, the value of the put option would increase if the covered index falls.

• Pros: If a bear market takes hold, the gain on the options contracts will help offset the decline in your equity positions.
• Cons: If the anticipated bear market does not materialize, the option contract could become worthless and the up-front investment could be lost.

6. Stay the course. If you follow a rules-based tactical asset allocation strategy that is designed to become more defensive as market or economic risk increases, continue to abide by the strategy. 

• Pros: This is certainly the easiest course of action.  It may also be the most logical, especially for a long-term investor. Remember that the reason to own bonds in the first place is not just the income that they generate. An equally important characteristic is the negative correlation of bonds with stocks.
• Cons: Given the lack of precedent for the world we find ourselves in, a strategy based on historic backtests might not be equipped to deal with the current macro-economic environment.

Of course, when it comes to investing, one size most certainly does not fit all. Instead how you should respond (if at all) depends on your investment objective, how long you intend to remain invested, your tolerance for risk, and so on. Hopefully the foregoing ideas will help you chart the course that is best suited for you.