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Lauren Young: The doomsday portfolio: How to invest for default

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What should investors do if they think their portfolio is facing doomsday?

It’s a question more folks have been asking me as the United States grapples with the prospects of debt default. On Thursday the U.S. Treasury will need authority to sell more debt securities — or face defaulting on its obligations. Another key date: Nov. 1. That’s when more than $55 billion in federal payments come due — and the Treasury might not have enough to cover those bills.

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Even as lawmakers consider short-term funding measures, every day that the government is partially shuttered and Congress and the president remain at an impasse is angst-inducing. Roughly one-quarter of individual investors have either increased their cash positions or postponed buying stocks, according to a recent poll by the American Association of Individual Investors.

In the past week, I’ve canvassed more than 20 money managers, strategists and financial advisers about the probability of a default. Collectively, they manage hundreds of billions of dollars. None of them predict an Armageddon for investors. And yet ... their anxiety level is amping up, even with the market’s rally on Thursday.

"As an investment professional, do I think we go through a default? No," says Stephen Sachs, head of capital markets at ProShares, which offers exchange-traded funds that allow investors to double down on the markets. "But I don’t assign a zero probability to it."

Adds Bruce Baughman, a veteran value investor at Franklin Templeton: "I’m no Chicken Little, but even I am starting to get nervous."

Few experts foresaw the breadth and depth of the 2008 financial crisis. Since then, though, we’ve all learned to expect the unexpected. It’s entirely possible that a U.S. default could trigger an unprecedented global financial meltdown.

If that isn’t scary enough, here is even more bad news: Investors have few places to hide. That’s because during cataclysmic markets, even hideouts like "cash," including really-short-term bonds and gold, suffer as well.

Yet there are a few ways to rejigger your holdings and hedge your bets. Some of these moves are exceptionally risky, so proceed with caution.

BET AGAINST THE BOND MARKET

If the U.S. defaults on its debt, the biggest portfolio blow-ups should happen within the market. Yields on bonds — particularly U.S. Treasuries — could rise sharply, and prices could fall just as fast.

That’s where inverse exchange-traded funds come into play. These high-octane funds short the market - moving in the opposite direction of major benchmarks, like the Barclays Capital 20+ Year U.S. Treasury Bond Index. Some inverse ETFs have extra juice — seeking to deliver double the inverse performance of the corresponding benchmark.

"If the U.S. defaults, the gains on these shorts would be astronomical," says Cliff Caplan, a wealth manager at Neponset Valley Financial Partners in Norwood, Massachusetts. He recommends buying the ProShares UltraShort 20+ Year Treasury ETF if you expect the United States to default on its debt. The ETF, which has an expense ratio of 0.93 percent of assets, is up 21.09 percent so far this year through Oct. 9. That’s compared to a 1.94 percent drop for the Barclays U.S. Aggregate Bond Total Return Index, which is a proxy for the U.S. bond market, according to Lipper, a unit of Thomson Reuters.

Another popular option to bet against bonds is ProShares UltraShort 7-10 Treasury ETF. Year to date, it is up 6.85 percent. The fund charges 0.95 percent for annual expenses.

"Caveat emptor," warns Tom Roseen, head of research services at Lipper, who says these volatile funds are not ideal for buy-and-hold investors.

Indeed, Caplan bought an inverse bond ETF in 2011 ahead of the ratings downgrade on U.S. debt by Standard & Poor’s. "I didn’t put a lot of money in it, but percentage-wise it was a disaster because interest rates went down, not up," he says.

FOCUS ON SHORT-TERM DEBT

Short-term debt isn’t as sensitive to interest-rate moves as longer-term debt.

That’s why Jessica Ness, director of financial planning at Glassman Wealth Services in McLean, Virginia, recommends ultra-short-term bond funds, including FPA New Income. It is up 0.38 percent for the year, according to Lipper.

The fund gets high marks from Lipper for capital preservation. (FPA’s motto: "We don’t like to lose money!")

The disclaimer here is that some institutional investors are dumping short-term debt because of worries that it will be defaulted on first.

Even so, "our concerns about the bond market remain about the same," says co-manager Tom Atteberry. Atteberry’s team is focusing on bonds secured by assets that, he says, "are critical to a business or individual, can be easily valued and can be foreclosed on in an efficient fashion in the event of default and the owner has equity invested along side us."

Some other bond funds Ness recommends: Franklin Adjustable U.S. Government Securities, which has an expense ratio of 0.62 percent, and Driehaus Select Credit. Both funds are essentially flat for the year.

BUY GOLD

Gold is considered to be the place to hide in the event of a market meltdown. Lately, it hasn’t looked especially safe — the price per ounce of the precious metal has fallen about 22 percent this year. And during the last financial crisis it lost luster, too.

"For doomsday clients, I typically recommend that they buy some gold - not in their portfolio as an investment, but rather as an insurance policy," says Carl Amos Johnson, a financial adviser at Ames Planning Associates in Peterborough, New Hampshire.

The easiest way to invest in gold is to buy the SPDR Gold Shares ETF. It is backed by a stash of gold bullion held in a vault in London.

Johnson’s advice, however, is to buy physical gold coins and keep them handy. Stash them in the treasure chest in your bunker - along with the batteries and canned goods.

LAUREN YOUNG is a columnist for Reuters.

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