How Income Investors Should React to Recent Market Volatility

I subscribe to the three-day rule, which says you should wait three days after a major financial story before you do anything rash with your money. So although it has only been three business days since traders and, evidently, a few investors started selling both stocks and bonds in a rejection of Ben Bernanke's rather muted clarification of future monetary policy, it's time to sum up the risks and the opportunities.

First, don't expect me or anyone else at Kiplinger's to scream "Sell!" on a dime. We don't operate that way. And despite the spike in interest rates that may strike some of you as cataclysmic, there are plenty of economists and fund managers who don't think rates are going up much more.

That group, by the way, includes the man who started this slide, Fed Chairman Bernanke. He said nothing last week about an imminent boost in the federal funds rate (the short-term rate that the Fed controls directly). And during the press conference that sent markets tumbling, he emphasized that the Fed's statement is not a change in policy but a clarification of what might be the policy later.

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Of course, just as singers sing, painters paint and writers write, traders trade. I am certain that some faction or other of traders and speculators was poised to sell their stocks as soon as the Fed spoke, guaranteeing that no matter what Bernanke said or how he said it, the Dow was destined to drop 660 or so points in four trading sessions, which it has.

The effect on bonds and interest rates is another matter. Perhaps the main takeaway from the stunning rise in yields — the benchmark ten-year Treasury has gone from 2.18% on June 18 through 2.54% on June 24 — is that so many people have the capacity to sell so many bonds (or stocks or funds) so quickly that a move that logically should occur over four months or longer now takes place in four days.

Can bond yields go higher and prices, which move in the opposite direction, lower? Perhaps, but not by a lot. If you figure inflation is currently running about 1% a year and the ten-year Treasury should yield two percentage points more than inflation, you could see the benchmark Treasury yielding about 3% by the time the current unpleasantness ends. Of course, markets have a habit of overshooting (as they did when they knocked the yield on the ten-year to a ridiculously low 1.39% in 2012), so it certainly wouldn't be shocking if the ten-year yield went roaring past 3%.

The continuing drop in stock prices — the Dow Jones industrial average tumbled 140 points, or just under 1%, on June 24 — is another matter. An improving economy, which the Fed sees as the justification for starting to taper back on its easy-money policy, should be a plus for corporate profits and share prices. The fact that stocks have fallen so hard suggests that investors have moved past the Fed story and are concerned that China and other developing countries are headed for serious trouble. Headlines about demonstrations in Brazil and Turkey are one thing. But slowing growth in China is a serious matter. If China's growth, which had been in double-digit percentages just a few years ago, slows to a 6% annual rate, as some experts conjecture, a big slice of the globe, from Australia and India and the rest of Asia to Africa, Brazil, Chile, Peru and beyond, feels the pain.

OK, three days are up. Now what do I do? Or not do? I am well aware that many of my favorite income investments have dropped by 10% or more in the past six weeks and have given back all of their 2013 capital gains. If you are strictly a total return investor and it doesn't matter to you whether that return derives from cash payments or appreciation, you may have a beef with me and my colleagues here for not flashing a sell signal. But because nearly all of my income picks are likely to keep paying interest and dividends, you shouldn't have expected one. We're not day traders here. We focus on the big picture. And our view of the big picture is that what's happening now can in no way be construed as a repeat of the 2008 financial meltdown. What's happening today is a traders' pity party.

We're especially mystified by the harsh selloff in U.S. blue-chip and high-dividend stocks because the U.S. economy is healthy, certainly compared with the rest of the world, and the balance sheets of U.S. companies are sterling. Perhaps the market is assuming that Brazil, India and China, as well as Nigeria and Thailand, will buy fewer tractors, jet engines and bars of soap from U.S.-based multinationals, but most traders aren't knowledgeable enough about Caterpillar or General Electric or Procter & Gamble to know that.

Stocks are not overvalued in comparison with corporate earnings and cash flow. They weren't that way when the Dow industrials stood above 15,300. Yes, some utilities and real estate investment trusts got expensive because a lot of yield chasers bid up their prices. But in the overwhelming majority of cases, their dividends are secure. If you bought, say, Federal Realty Investment Trust (symbol FRT) at $40 in early 2009 and it went to $119 in May and now fetches $97 but the dividends are going up, I'd say you have a $57-a-share gain and not a $22 loss. You own something that's fairly valued now, not overvalued. In my view, you should stand pat (especially if your gain is in a taxable account).

Bonds call for some obvious remedial steps. First, if you haven't done so, you need to shorten maturities. Then consider adding a floating-rate bank-loan fund and a high-yield bond fund, two categories that should hold up better than most during a period of rising interest rates. If getting tax-free income matters, buy short-to-intermediate-term municipal bonds.

We've been saying for quite a while to avoid long-term Treasury bonds and funds that invest in them. They weren't paying enough and were extremely vulnerable to rising rates. Rates haven't risen enough yet to make them attractive. If you own actual bonds, however, you can hold until maturity and get your principal back to reinvest at what should be a better yield (although what that money will buy you will depend on what happens to inflation, which for now at least is tepid). Ginnie Mae funds will start adding some mortgages that yield more, and holders of these government-backed securities will see fewer prepayments. I know Ginnie Mae funds have shed a bit of principal. But that will change unless interest rates go to the moon. They won't.

My biggest worry is that a new closed-end bond fund or leveraged mortgage REIT will blow up and set off a panic fueled by headlines that highlight that ever-present hazard I call "scoundrel risk." There are too many financial creations out there again. So I wouldn't invest money in a new mortgage REIT until the dust settles.

As for closed-end funds, we're starting to see some of the established ones trading again at a discount to net asset value. That's a place to start sniffing around. Those opportunities don't often last long. And neither do traders' pity parties.