The Key To Protecting Your Wealth From The Fed

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When I was a teenager, my father took me to an empty parking lot to practice driving on ice and snow. Skidding is an eerie feeling. When you first lose control of the car, your gut reaction is to step on the brakes.

But as I quickly learned, stepping on the brakes only makes it worse.

Steering the car where you want it to go and gently accelerating is the best way to regain traction on slippery pavement.

Maybe that's a strategy the U.S. Federal Reserve should consider.

For roughly three months, the Fed has been talking about cutting back on its asset-buying program. Currently, it is purchasing $85 billion in long-term Treasuries and mortgage backed securities in an effort to keep long-term interest rates low. But the Fed would like to slowly ease -- or taper -- out of this program.

This has proved, however, to be a slippery proposition.

The Fed has still not curtailed its program, yet long-term Treasury rates have already started to soar -- even past the point where the Fed is comfortable.

On August 21, the Federal Reserve released the minutes of its July 31 meeting. While the members still supported curtailing its asset buying program, they were divided as to when and how they should proceed. Mixed economic data had some members "less confident" about an uptick in the U.S. economy in the second half of this year. The recent rise in Treasury yields had already pushed up mortgage rates, and members viewed this as a threat to the recovery in the housing market.

The Federal Reserve has worked hard to be transparent about its plans and opinions. But when the central bank is divided, this transparency serves to magnify the uncertainty in the market. After all, would you want to be a passenger in a skidding car while the driver was unable to decide whether to brake or step on the gas?

Don't Let the Fed Make You Complacent
I have written about interest rate risk many times this year, starting with my January 2013 issue of The Daily Paycheck .

Fixed-income securities do have interest rate risk. But securities with short maturities and high yields -- referred to as "low-duration securities" -- have lower interest rate risk. The chart below shows how this has played out over the recent and dramatic rise in rates.

Almost all bonds and bond funds dropped in the weeks following the Fed's first mention of a policy change. But the short-maturity, high-yield bonds (as represented by HYS) bounced back. The longer-maturity high-yield bonds ( JNK ) stabilized. At the same time, the long-maturity low-yielding treasuries ( TLT ) continued to tumble.

The increase in interest rates has started to stall. Some investors feel the worst might be over. Maybe it is. Or maybe it is just the eye of the storm.

I still believe the environment is risky and uncertain for fixed income. This is not the time to get complacent. This is a good time to be vigilant about reducing the interest-rate risk in your portfolio. (If you are looking for information about the duration for any of your income holdings, funds typically provide this calculation on their websites.)

Earlier this year, I sold most interest-rate sensitive securities in my Daily Paycheck portfolio. I still, however, hold a number of fixed-income securities. Although they may come under some pressure if interest rates continue to climb, I'm more than happy to continue to hold them and reinvest dividends back into them.

After all, that's exactly the point behind The Daily Paycheck . We want to take advantage of the power of compounding to supercharge our income portfolios while limiting the amount of risk we take on over time.

Action to Take --> I continue to recommend funds like the PIMCO 0-5 Year High Yield Corporate Bond ETF ( HYS ) -- which pays a handsome 5% yield and carries very low interest rate risk -- to new investors. But I would not recommend rushing into any new fixed-income positions with higher durations until there is more clarity and stability in the market.




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas , Stocks

Referenced Stocks: HYS , JNK , TLT

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