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David Nelson: The Elephant in the Room Is the Bond Market

By David Nelson   |   Monday, 19 Aug 2013 03:40 PM

David Nelson is chief strategist of Belpointe Asset Management and a Moneynews contributor.

"Elephant in the room" is an English metaphorical idiom for an obvious truth that is either being ignored or going unaddressed. The idiomatic expression also applies to an obvious problem or risk no one wants to discuss.

The definition above comes directly from Wikipedia. For investors, the elephant in the room is of course the bond market. The risk of rising interest rates as the Federal Reserve exits its massive program of asset purchases is front and center.

However, today unlike other periods when lurking monsters hid beneath the surface, we all see the "elephant." You can't turn on a TV set, pick up a newspaper or read a financial newsletter without being hit in the face with the problem. The question is, "Are you doing anything about it?"

Editor’s Note:
399% Stock Market Rally Predicted (Buy These 4 Stocks Now)

The debate over the benefits of quantitative easing (QE) has continued since its inception. Most critics of the program would agree that the swift action taken during the height of the financial crisis in 2008 might have prevented the collapse of our banking system. Credit markets were under siege and the domino effect could have brought down far more than just Lehman Brothers. However, the benefits of QE in subsequent years are far less obvious.

If you measure success by asset prices and Wall Street performance, it's a home run. If you are looking at employment and growth in the real economy, the benefits seem less clear.

Frankly, the debate as to whether we should or shouldn't have doesn't matter anymore. The fact is we did it and the focus now needs to be, "What do we do now?"

Exiting chairman of the Fed, Ben Bernanke, has made it clear the fed is at the beginning stages of ending this program, and most economists believe the "tapering" will begin next month.

Wall Street strategists see the risks and offer a range of solutions. Unfortunately, most investors will do nothing until they see the whites of the eyes of the stampeding herd. Sitting in long-term Treasurys, corporate bonds and preferreds thinking you are in safe assets, thumbing your noses at equities is like an ostrich putting their head in the sand.

We are only just beginning to see outflows in bond mutual funds, so the panic certainly isn't upon us. Some like Joel Naroff, chief economist at Naroff Economic Advisors and a Moneynews contributor, believe the genie is already out of the bottle. In my recent interview with him for Newsmax, Naroff said, "The Fed has lost control of the long-term interest rates."

Widows & Orphans

Those in so-called widow and orphan stocks, like utilities, are also at risk. Utility investors like to point out that they always bounce back when interest rates turn. The difference is rates are at historic lows and could rise for some time, putting this sector particularly at risk.

Utility investors will find it very uncomfortable owning an asset that pays them a 4 to 5 percent dividend while their principal declines annually. With the exception of a few, most offer growth rates that are close to the gross domestic product, which is nothing to write home about.

In addition, payout ratios for many are high with little ability to make more than token raises in the dividend. If you are using this sector as a fixed-income alternative, dump it and move into master limited partnerships or even a fund like Goldman Sachs Rising Dividend Fund (GSRAX)

In his recent blog, Preparing Equity Portfolios for Rising Rates, Russ Koesterich, chief strategist for Blackrock answers his own question. "How should investors adjust their portfolios for slowly rising rates? Probably the simplest prescription may be to shift the portfolio mix toward stocks."

I agree, but unfortunately for older investors approaching retirement that may not be a solution.

What can you do?

Investors over 50 cannot nor should they put all of their assets in equities. Most will need some sort of balance. However, a diversified portfolio today should look far different than the typical balanced account of 20 years ago.

For decades Wall Street has preached the 60/40 split between bonds and stocks as a way to reduce volatility and preserve wealth. By placing 60 percent of your assets in stocks and 40 percent of your assets in bonds, you protected yourself from the inevitable bear market. Bonds would remain stable or appreciate when stock prices declined.

Today, the battlefield looks very different. In coming years, investors may be greeted by a bear market with bonds falling faster than stocks. Despite this scary scenario, there are still ways for balanced investors to cushion the ride.

Alternative Assets

Alternative assets have been with us for some time. Unfortunately, we often don't look beyond the headlines. Most investors aren't going to get access to Steve Cohen, Bill Ackman and the George Soroses of the world and given the recent headlines, maybe that's a good thing.

However, today's retail investors can choose from a wealth of mutual funds and strategies to help diversify their assets. Below are just a couple of choices.

Driehous Active Income (LCMAX) — Takes long/short bets on corporate bonds. The fund attempts to eliminate interest rate risk and seeks total return through security selection rather than making broad bets on the bond market.

Gateway Fund (GTEYX) — Gateway is a hedged equity fund that looks to reduce risk and increase income through a covered call strategy.

There are some great books on the subject, such as "The Alternative Answer" by Bob Rice of Tangent Capital. Bob is also the Alternative Investment Editor for Bloomberg TV. Click here to see my interview with Bob Rice for Newsmax.

The key here is that bond investors and bond mutual fund managers will have to think outside the box and use more sophisticated strategies to succeed. Top bond fund managers like Doubleline's Jeff Gundlach and Loomis veteran Dan Fuss recognize the challenges ahead for bond investors and will probably navigate the terrain better than most.

Even Bond King Bill Gross, who has been hit hard by redemptions in Pimco's flagship Total Return Fund (PTTRX), says the game has changed. In a recent interview on Bloomberg he vowed to win the war for assets.

The purpose of today's article isn't to give you a definitive strategy for the battle that lies ahead, but to force you to think. If I've done that, then today's mission is a success. The clouds are gathering, but there's still time to prepare. Remember, Noah built the ark before it started to rain.

Funds managed by David Nelson are long LCMAX and GTEYX at the time of publication.

Editor’s Note: 399% Stock Market Rally Predicted (Buy These 4 Stocks Now)

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For investors, the elephant in the room is of course the bond market. The risk of rising interest rates as the Federal Reserve exits its massive program of asset purchases is front and center.

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