Fight Fear by Getting Defensive

02/19/2009 12:00 pm EST

Focus: MARKETS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, warns of the consequences of the stimulus package, and advises how to protect your portfolio.

Fear and uncertainty are still with us despite promises of up to a trillion dollars in stimulus, or maybe because of such promises.

As investors, all this funding and spending could be viewed as a positive were it not for the law of unintended consequences. The biggest concern is inflation. Students of Nobel Prize economist Milton Friedman know that inflation is a phenomenon caused by creating too much money. The Federal Reserve has certainly been doing this in an unprecedented way, and it is far from certain that they can contain the inflation that historically results.

But then maybe the Fed sees inflation not as a problem, but rather as part of the solution. What better way to bail out debtors and clear out an excess housing inventory than through inflating the value of hard assets and at the same time diminishing the value of debt claims? That’s precisely what inflation does.

I don’t paint this scenario to depress you, but rather to alert you as to why you need to think defensively. But being defensive doesn’t necessarily mean foregoing yield in exchange for safety. The principal mistake to avoid is thinking any single strategy is a surefire winner. It’s imperative to be diversified.

Defensive strategies today include unloading most of your single-B and CCC-rated debt. Interest rates in this category are 16% to 30% if you can find a lender. This means that companies with such debt issues coming due will be hard put to roll the debt over—never mind finding fresh capital. And that’s assuming their profit margin is sufficient to cover such a heavy debt charge. In most cases it is not, which is why in a recession, companies dump inventories and scale back their operations so they can survive without fresh capital.

A safe defensive investment would be a security tied to the rate of inflation, such as Treasury Inflation Protected Securities, or TIPS. Their current yield on TIPS is only 1.74% plus the CPI inflation rate, which is accreted rather than paid out.

Canadian oil and gas trusts, which I have been recommending since 2004, are another class of defensive investments. They have been volatile, but they have been profitable. Currently these trusts yield 10% to 25% and are at five-year lows. However, most trusts have already cut their dividends to reflect current low oil and gas prices, so the upside potential here outweighs the downside. And don’t let tax law changes in 2011 concern you. They will have negligible effect on dividend payouts.

The ultimate defensive asset is, of course, gold. A 5% to 10% allocation here would be advisable given the inflation concerns. It is a better place to park cash than CDs or money market funds. Today, however, you should buy gold in the form of an exchange traded fund to avoid the 6% or so buy and sell charges for actual coin holdings.

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