5 Steps to Cushion a Bond Market Selloff

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with thestreet.com to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

NEW YORK (TheStreet) — Headlines of expected slowing corporate earnings, increased market volatility and a general distrust of Wall Street are keeping many investors out of stocks. No news there.

However, in spite of low interest rates and a general awareness that bonds are in “bubble” territory, many investors continue to buy bonds for their perceived safety. That’s news. If you are one of these investors, it’s a recipe for trouble.

In our view, investing in bonds in the current environment is just as risky as investing in stocks. As such, an active approach to selecting bonds, just like you would do with stocks, is necessary.

So there is no need to shun bonds altogether, any more than there’s a need to shun equities altogether when the investment landscape turns ugly. There is simply a need to rebalance and reallocate the bond portion of your portfolio.

For starters, remember why you invested in bonds in the first place. For most, bonds represent the “safe” portion of their portfolio providing a steady and reliable income stream.

As a result of the unprecedented interference by central banks, your bond portfolio may have taken on some very different characteristics. Instead of trying to talk you out of owning what I believe to be among the riskiest assets anyone can invest in right now, I will provide you with some strategies on how to reduce the risk of your bond portfolio.

Reduce the duration of your fixed-income portfolio. The GMG Defensive Beta Fund I co-manage is designed to provide equity-like returns with less volatility than the broader market. To help achieve the lower volatility, we hold bonds. The average maturity of bonds we own is less than four years. This greatly reduces the expected volatility of prices in bonds we own if interest rates rise rapidly (rising interest rates will cause bonds to lose value – the shorter the maturity of a bond, the lesser the impact of interest rate swings).

Don’t be afraid to take profits. As a result of the unprecedented lowering of interest rates by the Federal Reserve, many bonds are trading well above their redemption value. Unless you expect interest rates to drop further, take advantage of this capital appreciation. In our view, it’s unlikely to get better.

Go for yield. Granted, yield is a little harder to come by these days, but it’s there. In this arena, I like the State Street High Yield Bond ETF (SJNK), which has a yield of about 6 3/4%.

Remember to diversify your portfolio. Mix high-quality corporate bonds and municipal bonds. For corporate bonds, stay with AA-rated or better. On the muni side, stick with general obligation bonds, as GO bonds are not tied to a specific revenue source from a state or municipality, generally making them safer.

Cherry-pick. As you sell off some of your existing bonds or other holdings, incorporate some high-quality high-dividend-paying stocks. Don’t think of these as a replacement for your bond portfolio but as a supplement. Many of the stocks have a beta of about half that of the S&P 500 as a whole — very similar to some long-dated bonds.

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