John Wasik- Is hot money heading the wrong way?John Wasik

Troubles may dog the euro zone,
but in the U.S., stocks are on an ascent, with the S&P 500 up
about 12 percent in the first quarter. Apart from employment and
housing, there’s plenty of evidence that the U.S. is in a meek
recovery, which means that most of the hot money for short-term,
high-yield investments may be headed in the wrong direction.

Some $70 billion flowed into bond mutual and exchange-traded
funds from the start of the year through April 25, according to
Lipper, a Thomson Reuters company. That’s 10 times the amount
invested in large-company stock growth funds over those several
months, during which the exodus from stock funds was the largest
since 1996, according to EPFR Global. (More details here:).

This signals to me that either investors who were burned by
the 2008 financial crisis are still staying away from stocks, or
they don’t believe the stock rally is sustainable. That would
explain the continued retreat into corporate junk bond funds,
emerging market debt, U.S. mortgage securities,
intermediate-maturity bonds and all other forms of bonds.

Solely from a diversification perspective, these income
investors were doing the right thing. Yet, if interest rates
rise when the U.S. economy heats up even more, they are sitting
ducks for losses, as the value of many of these bond funds will
fall.

While the Federal Reserve said recently it doesn’t expect to
raise interest rates until 2014, there are signs that its policy
could change. In its April 25 Open Market Committee report, Fed
governors noted that “the economy has been expanding moderately.
Labor market conditions have improved in recent months; the
unemployment rate has declined but remains elevated. Household
spending and business fixed investment have continued to
advance.” (More details here:)

Only one Fed governor – Jeff Lacker – voted against the
current low-interest-rate stance. The statement said Lacker
“does not anticipate that economic conditions are likely to
warrant exceptionally low levels of the federal funds rate
through late 2014.”

It’s a good idea to give Lacker the benefit of a doubt if
you’re interested in not succumbing to the lemming effect, but
should you be concerned about inflation now?

RISKS

In the last five years, if we’ve learned anything, it’s that
big institutions like the Fed can be blindsided by tsunamis in
the credit markets. It’s probably too soon to fret, but
long-term it’s something to watch: Inflation still could pick
up.

One way to counter interest-rate risk is to ladder a bond
portfolio with single bonds. Stagger maturities from short-term
Treasury Bills or municipals to 10-year bonds. As the
shorter-term bills mature, replace them with similar maturities.
That way, you’ll capture any increased yields of newer issues.

As long as you’re buying and holding U.S. Treasury bonds to
maturity – and Congress doesn’t default on them – you won’t have
to worry about default, credit or interest-rate risk. You can
buy them directly through Treasury.gov.

The Treasury also offers I-bonds and Treasury Inflation
Protected Securities that pay a premium to standard Treasury
yields when the Consumer Price Index rises. These bonds can
offset losses in conventional bond funds – if you choose to hold
onto them.

Cash kept in federally-insured money-market deposit accounts
for bills and short-term needs is a still a safe haven, although
the yields are awful. You can find competitive yields on
certificates of deposit at bankrate.com, although “competitive”
these days tends to equate with paltry.

Should you want to take some more risk with a small part of
your income portfolio, consider the SPDR Barclays Capital High
Yield Bond ETF, currently yielding 7.3 percent or the
iShares J.P. Morgan USD Emerging Markets bond fund,
yielding about 4.7 percent.

It’s also a good time to look at the average duration of
your portfolio. This is a measure of how much money you’ll lose
if interest rates rise 1 percentage point. Your highest-duration
funds tend to be in longer-maturity bonds. If you’re concerned
about this kind of risk, then make adjustments now while
interest rates are relatively flat. The worst time to make a
move is when you see the edge of the bond promontory looming.