Band's Best: Defensive Steps

09/23/2005 12:00 am EST

Focus:

Richard Band

Editor, Profitable Investing

I have been a fan of Richard Band's for well over two decades. For a common-sense, safety-first approach to investing, few can match his time-tested skills. With his expectations for a more difficult market ahead, he suggests some steps to bolster your portfolio's defenses.

"Rising oil prices are already sowing the seeds of a major economic slowdown in 2006. As the pain at the pumps spreads through the country, three things will happen. First, the stock market will fall. So will home prices, as out-of-sight heating costs finally burst the real estate bubble. Then, with business slowing to a crawl, commodity prices (including oil) will fall. Finally, a cry for help will go up from consumers and businesses-a nd interest rates will fall. Investors who position themselves correctly at all three stages will reap fortunes. Those who misstep could lose their shirts.

"Keep an eye on the benchmark ten-year Treasury yield. My studies lead me to believe that the ten-year yield will peak between 4.5% and 4.75%, probably closer to the low end of the range. If it jumps past 4.5%, we would load up Treasury funds. One fund we recommend is Wasatch-Hoisington U.S. Treasury (WHOSX). Van Hoisington, veteran manager of the Wasatch fund, sports one of the best long-term track records in the Treasury sector. The fund only pays 4.1%, but in an environment of sharply falling yields, long Treasuries can deliver handsome capital gains. It's also worth remembering that Treasury interest is exempt from state and local income taxes. I'm projecting WHOSX will generate a total return (income plus capital appreciation) of at least 10%, and perhaps a tad more, over the next 12-15 months.

"We also suggest a position in a zero coupon bond fund, American Century Target Maturities Trust-2025 Portfolio (BTTRX). This is our turbo-charged vehicle. A year or so from now, if yields on long Treasuries have broken cleanly through their June 2003 lows (as I think they will), this fund should return 15% or more. As the name implies, zero coupon bonds pay no current interest. Instead, you buy them at a discount to face value and receive a lump sum at maturity. Because zeros don't throw off any immediate cash, their prices fluctuate much more than conventional bonds. When interest rates are falling, this added volatility can help you score dramatic capital gains. I'd note that even though you don't see any cash until they mature (or you sell), Uncle Sam expects you to pay taxes each year on the implied growth in the value of your zeros, so it's wise to hold your zeros inside a tax-sheltered IRA or other retirement account.

"If you're more interested in high current income than capital gains, I suggest buying a closed-end fund that invests in preferred stocks, such as John Hancock Preferred Income Fund (HPI NYSE) or its companions Preferred Income II (HPF NYSE) and Preferred Income III (HPS NYSE). Like bonds, preferred stocks pay a fixed cash income. All three of the Hancock preferred funds are yielding around 8%. But those lush payouts come with a caveat. The Hancock preferred funds are leveraged and with the Fed pushing up the cost of short-term borrowing, they've had to trim their monthly distributions. In fact, another round of cuts may be in the offing. Still, that's a risk I can accept in the latter stages of a credit-tightening cycle. Once the Fed reverses field, the Hancock funds should be able to start raising their payouts again. Meanwhile, I figure the funds will continue to yield at least 7.5%, well above what you could earn on an unleveraged portfolio of investment-grade preferreds.

"In addition to bolstering your defenses (and boosting your returns) with a slug of Treasury bonds, let's consider what you can do to strengthen the equity side of your holdings. My two favorite dividend-payers can both be snapped up now. Their lofty yields will help cushion your wealth in the critical months ahead. First, is Bank of America Corp. (BAC NYSE). With over $600 billion of deposits, BAC ranks as America's #1 retail banking chain. It's also a conservatively managed organization that maintains strong capital ratios and cautious lending practices. At ten times this year's projected earnings and yielding 4.6%, BAC is a standout bargain. Pay up to $45.

"A second current favorite is Verizon (VZ NYSE), America's biggest wireline phone company and the most successful wireless operator. Verizon is a titan with the heft and the cash to survive brutal competition in the telecom space. I wasn't a fan of its bid for MCI earlier this year, but the firm won me over with its first dividend increase since 1997. Hiking the payout sends a message that management expects plenty of free cash flow in coming quarters. The stock trades just 13 times this year's estimated net and yields a generous 4.9%. I recently added to my already sizable position in the stock. Buy at $36 or less."

Editor's Note: Everyone here at InterShow offers our congratulations and well wishes to Richard and Enid Band on the birth of their first grandchild.

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