Thursday, February 22, 2007

Buy some protection, or your house will burn down.

Jim Jubak - as well as other professionals whose opinions I worry about - has been warning for months about the danger of a massive debt-market meltdown. He has recently posted a note with advice for individual investors for protecting themselves from that meltdown.

His advice seems to be aimed largely at investors in equities, or in pretty standard types of bond funds, so I have decided to post some rather obvious pieces of advice for others who, like me, hold some of the odder forms of debt securities themselves. It can't hurt.

1. Stay diversified. At the moment, the best risk/return relationship looks like it's in financials. Don't let this lull you into putting too much of your debt portfolio into financials. In addition to more general dangers which can result from a lack of diversification, if there's a meltdown of the debt network, financials are going to get hit first and hardest. Obviously.

2. When evaluating risk, don't look only at the official ratings. As I've written (copied?) before, the past record of the debt-rating agencies is hardly stellar. For example, when looking at 'agency' CMOs, it's important also to look at the collateral on the individual CMO that you're thinking of buying. In most cases, the CMOs are collateralized only by the same loans that form the basis of the CMO, issued by the same agency. This is indeed collateral, but not of the most comforting kind.

On the other hand, aside from CMOs guaranteed by Ginnie Mae herself, and thus backed up by the "full faith and credit" of the US government, some of the CMOs issued by the privately owned 'agencies' are collateralized by GNMA debt. In my humble opinion, these are worth more, and especially now.

3. Very few people intentionally buy the debt of companies about to go bankrupt. People lose money on defaults because of a lack of knowledge of what's going to happen to the issuer in the future. In the financial markets, as in many other worlds, the farther you try to look into the future, the blurrier your vision gets. That means that in addition to whatever calculations you want to make about the yield curve, or whatever, it might be a good idea to buy shorter-term securities right now, as a means of reducing the chance of default if the rating agencies turn out to have made a mess of it. Again.

I can't guarantee that following my advice will keep you out of the poorhouse, but at least it will provide you with the pleasure of my company while you're there.

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