With the Federal Reserve likely to keep interest rates steady and the economy showing no signs of rebounding soon, investors are looking beyond stocks to find safer returns.
Among the vehicles attracting interest: exchange-traded funds that capitalize on a move downward in bond prices, short-term Treasury and municipal bonds, and fixed-income assets that help protect investors from a volatile stock market and uncertainty in the credit markets.
It's all part of a strategy to find safety as the market battles its way out of bear territory, the economy fights off a recession, and the Fed struggles to add liquidity to financial markets amid a high level of caution from lenders.
Cash is a popular position these days.
"In this environment it will still pay dividends to have cash, so you can take advantage of opportunities when they present themselves," says Dennis J. Barba, managing partner of the Oxford Group of Raymond James. "We haven't been committing any new money to equities since July of last year."
Quality CDs, Money Markets Hold Allure
Barba has been an advocate of municipal bonds, with their handsome yields and relatively low risk compared to some corporate or junk bonds.
Two-year municipal bonds are earning yields of about 2.45 percent—lower than Treasurys— but 10-year issues are at 4.18 percent and 30-year muni bonds are delivering a solid 5.13 percent compared to federal government debt.
Barba still likes munis, but has widened his horizon a bit in part because of a shortage of offerings in the area.
A still-wide yield curve—the difference in yields between longer- and shorter-dated debt—has curbed many investors' appetites for longer-term moves in the bond market. But Barba says certificates of deposits issued by investment banks as well as institutional money market funds provide short-term cover while the Fed measures its next move.
Five-year CDs are paying 4.26 percent while 6-month certificates are at 3.18 percent, while money markets average 2.95 percent but vary widely between banks. With annualized inflation around 5 percent such positions actually lose money in real terms, but provide safety in uncertain times.
Barba thinks the Fed will hold steady on rates then make a hike next year, providing stronger yields in 2009.
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"My inclination is we'll see rates higher at the beginning of 2009 than they are now, so I'm not going out too far on the yield curve. If that thought process holds correct you'll be able to get some better yields early next year," says Barba, who sees 5 percent yields a possibility in some notes. "Psychologically that seems to be a number where people don't mind parking their money."
Short on Treasury Bonds?
Mike Larson of Weiss Research also sees the Fed moving higher and believes that will have negative repercussions on bond prices. He sees longer term Treasurys as an unwise investment in the current interest rate environment.
As such, he likes the ProShares UltraShort Lehman 20+ ETF that capitalizes on lower prices in long-dated government debt and pays investors double the moves downward in the bond market. Though it has only been on the market a few months, the fund is attracting increasing interest.
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"It makes sense to stay out of the longer-term Treasury curve," he says. "Stick to shorter-term stuff. The next move for the Fed probably is going to be an increase."
Larson also is watching how the Fed's efforts to boost lending and help the real estate market is playing out. He says betting against any sharp increases in housing is probably safe now.
He backs another inverse fund, the ProShares UltraShort Real Estate, which also pays investors double for downward moves of the Dow Jones US Real Estate Index.
"The Fed is sort of leading the credit horse to water but it can't make it drink," Larson says. "While the Fed may be making money cheap in trying to liquefy the credit markets, the lenders are in hunker-down mode."
Muni Bonds Play Politics
Michael Cohn, of Atlantis Asset Management, backs municipal bonds, which he says will benefit even more should Barack Obama be elected president.
Higher tax rates likely under the Democratic nominee will increase demand for munis as governments will have more liquidity and be able to take on more ambitious works projects and have more capital backing.
"The ratings are going to go up by default. They should be rated higher," Cohn says. "The tax rates are threatened to be raised in the long term. That will be good for munis. If you're looking to ride out the storm here and get some yields, I think these are good relatively low-risk places to park your money given the uncertainty with the political landscape."
Cohn also is looking at preferred stocks, particularly in investment banks, which he recommends "you kind of nibble at" until the picture in financials gets clearer.
Fixed Income as an Inflation Hedge
The Fed's rate-cutting spree, as well as its willingness to hold steady as the economy battles a recessionary climate, has some criticizing the central bank for allowing runaway inflation.
Matthew Tucker, head of investment strategy at Barclays Global Investors, has three ETFs that follow fixed income trends and provide a hedge by investing in assets that are resistant to inflation.
The iShares Lehman TIPS Bond is indexed to Treasury Inflation-Protected Securities. The principal of TIPS increases with inflation and decreases with deflation, making it a popular vehicle when inflation is around a 5 percent annualized level.
"Historically they've had a low correlation with other major asset classes such as bonds and equities," Tucker says. "They can provide diversification in a broad portfolio."
Tucker also recommends the iShares Lehman Aggregate Bond fund, which corresponds to the bond market as defined by the Lehman Brothers Aggregate bond index. The fund is limited to mostly high-quality issues with liquidity.
And he also likes a fund that is indexed to high-quality mortgage issues, the iShares Lehman MBS Bond, which invests only in mortgages backed by government-sponsored enterprises Fannie Mae and Freddie Mac .