COLUMN-Circuit breakers investors can use for a debt default

Reuters

By John Wasik

CHICAGO, Oct 7 (Reuters) - In times of calamity, everyportfolio needs a set of circuit breakers.

And, as Congress speeds toward the debt-ceiling barrier, itis a good idea to consider some inverse exchange-tradedfunds(ETFs) that move in the opposite direction of stock andbond indexes.

The first major hurdle is Oct. 17, when the Treasury willneed authority to sell more debt securities - or face default onits obligations. What if markets get spooked over Washington'sinability to reach a consensus on fiscal matters? If traderstruly believe that Congress won't issue more debt to pay billsit has already racked up, that will send interest rates onTreasury paper soaring.

You can hedge political risk a number of ways with inverseETFs. One worth considering is the ProShares Short 7-10 TreasuryETF, which gains if Treasury bond yields rise (andprices drop). During the past year through Oct. 4, the fund rose2.4 percent, compared with a negative 1.7 percent return for theBarclays U.S. Aggregate Bond Total Return Index, a proxy for theU.S. bond market. The fund charges 0.95 percent for annualexpenses.

Of course, a debt-ceiling duel would do much more thandepress bond prices and the damage the faith in the credit ofthe U.S. government. It would severely cripple the U.S. economyat large. Government would have to cut spending by at leastone-third. That means everyone from defense contractors toSocial Security recipients would have to wait for their checks.Another recession could be triggered.

Jack Ablin, chief investment officer of BMO Private Bank inChicago, puts it bluntly in a recent analysis: "Whileeventually business as usual will be restored and the stockmarket will ultimately recover, closing down 18 percent of oureconomy will leave a mark. Defaulting on Treasury obligationswould foist the nation into a financial tailspin."

The stock market would eventually feel this pain mostacutely. One way of hedging against that is the all-purpose bearETF, the Direxion Daily Total Market Bear 1X ETF. Ittracks the reverse performance of the MSCI U.S. Broad MarketIndex, and charges 0.67 percent of assets annually. Since U.S.stocks as measured by the S&P 500 Index are having a good year -up 16 percent through Oct. 4 - the bear fund is down nearly 19percent through Oct. 4.

A softer approach than shorting an index would be to own aportfolio that's already well hedged.

The Permanent Portfolio mutual fund is designedfor nervous nellies who don't want to be overexposed to U.S.stocks or bonds. About one-third of the portfolio is in stocks;one-quarter in gold and silver bullion and coins; 27 percent inbonds and the remainder in cash. It charges 0.69 percent forannual expenses.

Since the entire Permanent fund is oriented toward thecircuit breaker strategy, it doesn't do well when U.S. stocksare soaring and gold is dropping, which has been the case formost of the year. It's down 3 percent in 2013 through Oct. 4.The fund only lost 8 percent in 2008 when stocks were off 37percent.

GAUGING VOLATILITY

Wall Street is much less nervous than Main Street about thepossibility of a default - at this moment. But if you need topreserve principal and you're relying upon your portfolio forincome, it's important to watch the CBOE VIX Index, a gauge ofdaily stock volatility, to see how the markets are reacting toWashington.

After hitting a yearly high of 22 toward the beginning ofthe year, the VIX index dropped by half in March, but has sinceclimbed to more than 18 in the recent week. Still, those aren'tterribly nervy numbers compared to 2008, when the VIX hit 80.

Nevertheless, sit down and see where you could get hurt themost. Where do you have the greatest risk exposure? If yourportfolio is mostly bonds, then you'll need to protect yourselfagainst rising interest rates.

Keep in mind that the major drawback with inverse ETFs isthat their performance will be negative when the markets theymirror are in positive territory. They should be regarded ascatastrophic insurance and not mainstream investments.

Also be careful with their leveraged ETF cousins that allowyou to gain two to three times if a specific index declines.They are not for the inexperienced investor and should be boughtwith stop-loss limits through your broker. Know how much you canlose with these dangerous vehicles.

Whatever route you take, don't think you can time what themarkets - or Washington - will do. Chances are you will guesspoorly and lose money. Most investors are late to the game andeven later to get back in when the markets recover.

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