Rational Investing: Mutual funds offer better return than bonds

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.

I haven't heard from Jimmy the Oracle yet, but I expect to by the time this issue reaches you. My guess, based on his low tolerance for pain and knee-jerk reaction to every bit of bad news he hears on TV, is that he is going to hit the panic button because of the interest-rate situation.

It wasn't that long ago that he and I had our discussion of interest rates relative to an improving economy.

It went something like this: In an improving economy, the bond market will start anticipating the Federal Reserve raising interest somewhere between six and nine months before such increases in the discount rate actually take place. Simply put, the market does Mr. Greenspan's work for him in the early stages of a changing interest-rate scenario.

Jimmy will probably exhibit his "wrong side of the market" action by selling his stocks. That's if he has owned any during this bull market, since his nature is to buy at the top and then throw in the towel at the bottom.

As you recall, Jimmy runs to certificates of deposit or savings accounts at the slightest whiff of what he perceives to be bad news that he hears on CNBC.

Another of his favorites he no longer talks about are Ginnie Maes, which I've explained aren't right for him unless interest rates are stable.

He just doesn't understand that in declining interest rate periods, homeowners refinance at lower rates, paying off old mortgages, thus GNMA holders start getting their principal back in a low interest rate environment in which they cannot replace the yield they are losing. In a rising interest-rate cycle, previously issued GNMAs will see their market value decline. Bottom line: If Jimmy wants to own them, he should do so when interest rates are stable, and he has no problem dealing with getting interest payments and a return of his principal sent to him regularly.

As for the certificates of deposit, well, poor Jimmy will be going in the hole on an after-tax, inflation-adjusted basis, but maybe he can live with that. I'd rather see him own equity in companies that pay dividends and increase them regularly. There are plenty of those available for the knowledgeable investor with a time horizon longer than the settlement date. Last week alone 19 companies reported dividend increases a fairly typical weekly average during earnings reporting season in this economic cycle.

(If you are interested in selecting stocks in this category check out the screening tools on Yahoo! or any number of Internet sites, or head for the library and use Value Line.)

Back to interest rates. Historically, the first increase in interest rates initiated by the Fed causes a very short-term downward blip in the equity markets, but nothing serious as the markets have already discounted the increase, as mentioned above. Interestingly, the majority of the time markets react very positively in the six months following the initial increase. Why? Because the increase is a consequence of an expanding economy and increased demand for capital.

In other words, business is booming, earnings are growing, companies are hiring and expanding at above-normal rates, and stocks are appreciating.

That doesn't mean it has to happen that way this time, but remember the folly of thinking, "This time it's different."

Is your question, "What do I do now in the bond allocation of my portfolio to deal with rising interest rates?"

Here are two steps you can take, depending on how aggressive you want to be. First, if you are a conservative investor who uses a laddered maturity method of bond ownership, you should be fine. If you have laddered the maturities fairly equally in a manner that provides for a bond maturing every six months or so, with the longest maturity no greater than seven years, stay the course. If you have bonds with maturities longer than seven years, replace them with shorter maturities that fit within your ladder. Remember, this technique is designed to allow you to regularly adjust to changing interest rates. You will never have all your funds invested at the lowest rate nor will they all be invested at the highest rate. Over the long run, this method has handily beat the performance of most bond fund managers.

Is your risk tolerance moderately aggressive or aggressive? Ask your financial professional about the potential to take advantage of rising interest rates by owning a mutual fund that has an inverse correlation to owning the 30-year Treasury. Two come to mind: the Rydex Juno fund and ProFunds Rising Rates Opportunity Fund. If interest rates on the long government bond climb up over the next several years, these funds could offer substantial potential for appreciation.

Oh yes, don't worry I doubt that Jimmy The Oracle will own either of them.