The Incredible Danger in "Safe" Investments

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Many safe-haven investments have hit the point of being absurdly bubble-priced. U.S. Treasury bonds are the poster child for that insanity. It has gotten to the point where as of Friday, even the 30-year bond had a yield below inflation. In other words, unless inflation reverses course, you're essentially guaranteed to lose money in real terms by lending it to the U.S. government by buying those bonds.

That's not a sustainable situation. Smart investors don't go out of their way to lose money, even when there's a government guarantee attached. At some point, the market will demand positive real returns for the risks investors are taking, and when that happens, the bubble will burst.

How bad will that be?
Assume, for instance, that investors start requiring a mere 1% more on those 30-year bonds -- a move from 3.53% to 4.53% based on Friday's rates. Based on their modified duration, existing 30-year bonds will drop an astounding 18.4% to reach parity at those new higher rates. That's a huge swing in the current value of a supposedly low-risk asset like Treasury bonds.

And it's not like 4.53% yields on Treasury bonds are unheard of. Just five months ago, 30-year Treasuries were priced in that range. Oh sure, unless the government defaults on its debt, Treasury investors will get every penny of par value back at maturity -- but 30 years is a long time to wait just to catch up.

The true risk in these supposedly low-risk assets becomes very apparent as soon as you ask yourself what happens when interest rates rise. At current levels, it doesn't take much movement in rates to translate into gigantic swings in price on those long-term debts.

Buffer your income from rate hikes
While there is still no such thing as a completely risk-free investment, there are ways to better insulate your portfolio from the risks of rising rates. Almost ironically, these days, stocks might provide better protection than bonds do, especially against the risk of rising rates.

But not just any stock will do. In fact, there are only a handful of stocks that look capable of providing that sort of protection against rates, including these:

Company

Debt-to-Equity Ratio

Current Yield

Payout Ratio

1-Year Dividend Growth

5-Year Compounded Dividend Growth

Intel (NAS: INTC) 0.054.3%30.3%13.8%13.5%
Sanofi (NYS: SNY) 0.385.1%32.1%4.2%10.5%
ConocoPhillips (NYS: COP) 0.404.0%30.2%19.8%12.5%
Lockheed Martin (NYS: LMT) 1.534.1%36.0%17.1%20.2%
Sempra Energy (NYS: SRE) 1.023.8%34.1%11.5%8.1%
Darden Restaurants (NYS: DRI) 0.863.8%36.8%28.0%26.2%
Molex (NAS: MOLX) 1.534.1%36.0%17.1%20.2%

Source: Capital IQ, a division of Standard & Poor's.

What makes them worth considering is this rare combination of traits:

  • Debt-to-equity ratio below two. This indicates that the companies haven't overleveraged themselves and thus have some ability to ride out any further rocky patches in the economy. That's critical if you're looking for a buffer against rising rates, since companies that have high debt levels can see their stocks suffer as their debt financing costs increase in response to higher rates.
  • Current yields above Treasury bonds. Each of these stocks sports a dividend yield above the 3.53% on the 30-year Treasuries. With higher yields, you get both better income now and better protection against higher rates.
  • Payout ratios below 50% of earnings. Payout ratios below half of earnings indicate that the company is retaining sufficient money to grow its business (and its dividends) in the future. That's important if you're looking for dividend growth to protect your portfolio value against rising rates, since today's reinvested earnings provide the fuel for tomorrow's dividends.
  • Decent history of dividend growth. All these companies have seen their dividends rise faster than inflation's 3.6% pace over the past year. Their dividend trends look decent when compounded over the past five years, as well. While dividends (and their growth) are not guaranteed, dividends' signaling properties provide corporate boards' incentive to keep those trends going once they're established. And with decent balance sheets and low payout ratios, the incentive is likely to remain strong.

Manage your risk/reward trade-off
Yes, companies can go bankrupt and their stocks become worthless, and dividends do get cut. But compare the risks of a well-diversified portfolio of companies with solid financial strength and histories of growing dividends with the certain 18.4% loss in long-term bonds when rates rise a mere 1%. You just might find that with a long-term time horizon and a definition of risk that includes interest rates, the risk/reward trade-off favors well-picked stocks.

As the market wakes up to that reality and starts demanding higher rates, the incredible danger priced into "safe" investments will become apparent. At that point, as with most market adjustments, it'll be too late for ordinary investors to do anything about it.

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At the time this article was published At the time of publication, Fool contributor Chuck Saletta owned shares of Intel. The Motley Fool owns shares of Lockheed Martin and owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares and creating a diagonal call position on Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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