Is hot money heading the wrong way?

CHICAGO Fri May 4, 2012 5:11pm EDT

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CHICAGO (Reuters) - Troubles may dog the euro zone, but in the U.S., stocks are on an ascent, with the S&P 500 up about 12 percent in the first quarter. Apart from employment and housing, there's plenty of evidence that the U.S. is in a meek recovery, which means that most of the hot money for short-term, high-yield investments may be headed in the wrong direction.

Some $70 billion flowed into bond mutual and exchange-traded funds from the start of the year through April 25, according to Lipper, a Thomson Reuters company. That's 10 times the amount invested in large-company stock growth funds over those several months, during which the exodus from stock funds was the largest since 1996, according to EPFR Global. (More details here: link.reuters.com/quq97s).

This signals to me that either investors who were burned by the 2008 financial crisis are still staying away from stocks, or they don't believe the stock rally is sustainable. That would explain the continued retreat into corporate junk bond funds, emerging market debt, U.S. mortgage securities, intermediate-maturity bonds and all other forms of bonds.

Solely from a diversification perspective, these income investors were doing the right thing. Yet, if interest rates rise when the U.S. economy heats up even more, they are sitting ducks for losses, as the value of many of these bond funds will fall.

While the Federal Reserve said recently it doesn't expect to raise interest rates until 2014, there are signs that its policy could change. In its April 25 Open Market Committee report, Fed governors noted that "the economy has been expanding moderately. Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated. Household spending and business fixed investment have continued to advance." (More details here: link.reuters.com/vaf87s)

Only Jeffrey Lacker, Federal Reserve Bank of Richmond president, voted against the current low-interest-rate stance. The statement said Lacker "does not anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate through late 2014."

It's a good idea to give Lacker the benefit of a doubt if you're interested in not succumbing to the lemming effect, but should you be concerned about inflation now?

RISKS

In the last five years, if we've learned anything, it's that big institutions like the Fed can be blindsided by tsunamis in the credit markets. It's probably too soon to fret, but long-term it's something to watch: Inflation still could pick up.

One way to counter interest-rate risk is to ladder a bond portfolio with single bonds. Stagger maturities from short-term Treasury Bills or municipals to 10-year bonds. As the shorter-term bills mature, replace them with similar maturities. That way, you'll capture any increased yields of newer issues.

As long as you're buying and holding U.S. Treasury bonds to maturity - and Congress doesn't default on them - you won't have to worry about default, credit or interest-rate risk. You can buy them directly through Treasury.gov.

The Treasury also offers I-bonds and Treasury Inflation Protected Securities that pay a premium to standard Treasury yields when the Consumer Price Index rises. These bonds can offset losses in conventional bond funds - if you choose to hold onto them.

Cash kept in federally-insured money-market deposit accounts for bills and short-term needs is a still a safe haven, although the yields are awful. You can find competitive yields on certificates of deposit at bankrate.com, although "competitive" these days tends to equate with paltry.

Should you want to take some more risk with a small part of your income portfolio, consider the SPDR Barclays Capital High Yield Bond ETF, currently yielding 7.3 percent or the iShares J.P. Morgan USD Emerging Markets bond fund, yielding about 4.7 percent.

It's also a good time to look at the average duration of your portfolio. This is a measure of how much money you'll lose if interest rates rise 1 percentage point. Your highest-duration funds tend to be in longer-maturity bonds. If you're concerned about this kind of risk, then make adjustments now while interest rates are relatively flat. The worst time to make a move is when you see the edge of the bond promontory looming.

(This version of the story has been corrected to fix Jeffrey Lacker's title in 6th paragraph from Fed governor to Federal Reserve Bank of Richmond president)

(Editing by Beth Gladstone)

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