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The Alternative Answer Daily

Liquidity Detox: Prepare For The Shakes

This article originally appeared on forbes.com.

Volatility is back, and unpacking for a long stay. June will set a 2013 record for days with 100-point swings, and the Vix is headed north. But the real story is in bonds, where total returns for the year — interest income plus or minus price movement– actually went negative last month before popping back to even. So much for the safe, non-volatile part of your portfolio.

Those tremors warn of bigger convulsions ahead. Liquidity detox is no fun; and the markets will probably see a full blown case of the shakes during its coming rehab.

We all know how the central banks, in the emergency room of 2008, began main-lining cash into the world economies, warding off likely deflation and forcing stock and bond prices higher. But like narcotics for pain, the drug itself has become the problem. Now, the barest hint that the dosage might be scaled down sends the markets into fits. Indeed, the only thing that matters about any new economic data point is not what it directly means for growth, but rather how the Fed, BOJ, and ECB might adjust their easy-money programs as a result.

The market’s increasing nervousness is natural. All the central banks are very far down unexplored paths; every change produces results that, by definition, are unpredictable. Just last week, the director of financial stability of the Bank of England, Andy Haldane, told Parliament that what keeps him awake at night is prospect of “a disorderly reversion in the yields of government bonds globally.” In our version of English? The shakes.

“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history. We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted,” Haldane said.

It’s not just that the bankers may mismanage the great unwind. Even if they do a wonderful job, there’s some nasty math to overcome. Uber-low interest rates create what finance types call “duration” or “interest rate” risk: even a tiny uptick in interest rates generates a disproportionately large value destruction for bonds. (For more explanation of these terms, check out the educational videos at www.altanswer.com.)

For example, for most of last week, ten year Treasury bonds were losing a full one-tenth of a percentage point of value for each one-hundreth of a percent of interest rate increase. That’s right: a ten-to-one ratio. Whoa.

So imagine what happens to Treasuries if rates increase back to a more natural 4 or 5 percent, from the current 2. The expected losses in a portfolio of medium term bonds would be something around one-third of its value. That’s a risk most adherents of the classic 60/40 portfolio don’t understand.

But it shouldn’t be surprising: after all, something like 85% of bond investors’ total returns over the past decade have been from the flip side of the same coin: price appreciation as rates went from low, to lower, to microscopic. And pendulums do swing both ways.

So consider how this plays out, even in an economy that really is improving over all. We all know how central housing is to the recovery theme, but even small increases in mortgage rates will translate into major impacts on housing affordability. That will likely create fear that the recovery can’t be sustained… which could easily push investors out of stocks and back in to bonds. Bond yields retreat, and the cycle restarts.

It’s the financial market version of those drinking bird toys, the ones that duck their heads into water, only to have temperature and pressure changes make it straighten up again, over and over. So, even if the central banks complete their heroic mission flawlessly, we’re likely looking at a strong sawtooth pattern for the markets. And if they stumble along the way, well… let’s not go there.

How can investors prepare? On a general level, through ever greater diversification across asset classes and strategies. The broader your base, the better you can absorb losses in particular sectors, and the more chance you’ll find winners in an unpredictable recovery.

But more specifically right now: lower your exposure to traditional bonds. That’s where the volatility– in terms of percentage moves– is likely to be the greatest.

Especially for retirees and others who look at bonds as the safe, stable anchor of a portfolio, the next couple of years might be rude. Look for substitutes that can increase payouts over time, like MLPs, leveraged loan funds, BDCs and multiclass ETFs; and/or for bond funds that minimize duration risk, like the long/short credit funds this column has mentioned previously. TIPS have gotten cheaper lately and are also worth a look.

If you have the tolerance for less liquid investments, some SBIC loan funds can generate nice current returns and a equity kicker in the case of good performance. Other top choices include specialty finance funds that focus on asset-backed deals (with investments in everything from equipment leases to slot machines).

At a minimum, switch to shorter term, amortizing loans that react less to interest rate changes; one possibility here is peer to peer lending, via sites like Lending Club and Prosper.

Those kinds of investments will help you get through the shakes without too much sweat. And many more prescriptions for volatile markets are in my new book, The Alternative Answer.