HOW TO PLAY IT-Yellen surprise suggests investors should go on defense

NEW YORK, March 23 Sun Mar 23, 2014 11:43am EDT

NEW YORK, March 23 (Reuters) - Investors worried the Federal Reserve will start raising interest rates in a year's time or even sooner should stick with shorter-maturity bonds, high-quality corporate debt and stocks with attractive dividends like utilities.

These defensive-oriented securities should offer a cushion against any sudden declines in the broader stock and bond markets while providing steady income at a time when the Fed is edging toward the end of its ultra-low-interest rate policy, analysts and portfolio managers said.

"Many people are still hunting for yields when they should be hunting for safety," said Carl Kaufman, a portfolio manager at Osterweis Capital Management in San Francisco. "I would just be careful."

No one expects the Fed to lift rates in the near term. Still, comments this week from Janet Yellen, who just took over as Fed chair, caught many in the market off guard when she suggested the central bank may be in a position to raise its key interest rate as soon as six months after ending its massive bond-buying stimulus.

That could put the first rate hike on the table by the spring of 2015 compared with previous expectations for no sooner than the second half of the year. Indeed, rate futures markets now assign a 52 percent probability to the Fed's April 2015 meeting for the first rate hike versus just a 33 percent chance a month ago.

To be sure, the economy continues to grow at a subpar rate, which could help keep bond yields near their historic lows. Tensions between Russia and the West over Ukraine and uncertainty about the health of the Chinese economy could hurt U.S. and global growth and prompt the Fed to keep interest rates low for longer.

STICK WITH SHORT-DATED BONDS

But those who would rather not deal with the risk of an earlier move by the Fed should reduce their holdings of longer-dated bonds in an effort to trim their "duration" risk so they could avert losses if interest rates rise further. Bond yields and prices move in opposite directions.

Meanwhile, top-rated corporate bonds will continue to provide some income while featuring lower price volatility than lower-rated junk bonds and bank loans, which have enjoyed big demand throughout the era of the Fed's financial crisis-driven stimulus programs.

Heather Loomis, West Coast director at J.P. Morgan Private Bank in San Francisco, said long-dated Treasuries, municipal bonds and securities from agencies like Fannie Mae are especially vulnerable to another surge in yields. "Reduce duration so you are less sensitive to the upward rise in yields," she said.

She said the average duration of her portfolios is about 2.5 years, half of most widely followed U.S. bond indexes.

Exchange-traded funds focused on shorter duration bonds and those with defined maturity are alternative vehicles that mitigate concerns about rising rates, said Matt Tucker, iShares head of fixed-income strategy at BlackRock in San Francisco.

"The strongest trend we're seeing now is the move into short maturity fixed income," Tucker said, like the iShares Short Maturity Bond ETF, which includes a range of U.S. dollar-denominated short-term bonds, primarily investment grade, with an average duration of one year or less. [ID: nL2N0HK2AK] The fund, with about $210 million in assets, has had inflows of about $35 million so far this year, according to Lipper data.

Steve Sachs, head of capital markets at Proshare Advisors, suggested short-dated, floating-rate bonds as another way to hedge against rising rates but noted their returns are lower than fixed-rate counterparts.

For speculative types, Sachs said there are ETFs that bet on a further drop in bond prices.

The Proshares short 20-year Treasury ETF, whose price rises when the Barclays' 20-year Treasury index falls, gained 0.85 percent on Wednesday, while Barclays' long-dated Treasury index lost 0.76 percent. The $1.5 billion fund has had net outflows of about $81 million so far this year, Lipper data shows, although it drew record inflows in 2013 of nearly $800 million.

STOCKS: TURN ON THE LIGHTS

Low-volatility and higher-yielding stocks such as utilities could be an option for those in the equities space who may want to steer clear of some of the hotter stocks and sectors of 2013 that are now richly valued.

In fact, utilities are already gaining favor after three years of lagging the wider market. The S&P 500 Utilities Sector Index is up nearly 7 percent year to date on a total return basis compared with less than 1.5 percent for the S&P 500 on a comparable basis.

If the market becomes convinced the Fed will act sooner than later, "fixed income portfolio (values) are about to drop as yields increase," said Diane Garnick, founder and CEO of Clear Alternatives, an asset management firm in New York. "One of the safe havens, of course, is high yielding equities."

"It happens that utilities, because they're highly regulated, tend to be a little safer than some of the other equity names that are out there, and so I think that's one of the reasons that utilities in particular are doing well," Garnick said.

All but six of the S&P 500's 30 utility stocks have beaten the wider market so far this year. On top of that, the group sports an average dividend yield of 3.87 percent, more than a full percentage point above the 10-year Treasury note's yield of 2.74 percent. (Additional reporting by Ryan Vlastelica, Ashley Lau and David Gaffen; Editing by Dan Burns and Martin Howell)

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