Thursday, June 29, 2006

Moving on up in the capital structure

The recent increase in the awareness of market volatility has left people asking the same question that Vladimir Lenin asked in 1902. What is to be done?

The simplest answer is to move up in the capital structure by owning bonds. Because of uncertainty about the movement of interest rates, the best choice is something that is fairly insensitive to interest rate fluctuations. Sensitivity to interest rates is mostly dependent on an bond's duration and coupon interest rate. Higher interest rates and shorter time to maturity mean less sensitivity.

Both of these desirable attributes are found in floating rate income funds. These are mutual funds which invest in junk bank loans. These loans are repackaged in the form of floating rate notes, which then trade in the OTC market. Although the obligors tend have fairly poor credit (BB and B), the bank loans are the most senior debt in the capital structure. The combination of high interest rates, ultrashort duration, and seniority make investing in bank loans very profitable and yet safer than investing in junk bonds.

For example the Fidelity Floating Rate High Income Fund (FFRHX) is currently yielding 6.16% and over the past 12 months the share price has fluctuated between $9.93-$9.99. That does look quite nice when compared to the current market gyrations.

I think it is silly to talk about reducing market exposure via short ETF and exotic options strategies when the simplest solution is to directly reduce your exposure. I.e. by selling broad based ETF's/mutual funds that are core portfolio holdings.If your portfolio is scattered between 10 different funds, then now is good time to think about consolidating it.

Equity investments are correlated with each other. You aren't gaining much by investing in 10 different slices of the same cake. At the same time you are losing flexibility as well as having higher trading costs when making changes in allocation. Reinvesting capital that is now in stocks into cash assets and fixed income is the best way to reduce market exposure while gaining real diversification.

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