No Matter How Safe You Think Your Money Is, Protect It With This

Problems in Detroit may have been developing over many years, but there were still surprises when the city announced that it was filing for bankruptcy. No one who is in line for payments due from Detroit is 100% safe. In the bankruptcy process, creditors, employees and retirees are all at risk of seeing their payments reduced.

Retirees have usually been protected to some degree in bankruptcy proceedings. When a company goes bankrupt, there is a federal agency that guarantees pensions will be paid. The amounts may be reduced, but the retirees who are affected by the process can obtain information about their benefits even before the bankruptcy is filed.

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This time is different. The bankruptcy judge may be asked to reduce the pensions of retirees and there is no law that defines what to expect from that ruling. Uncertainty has replaced the security of a defined benefit pension.

Pensions are a form of investment. This is obvious with many retirement plans, like IRAs or 401(k)s, that are funded each year and grow tax-deferred. It is also true of defined benefit plans, which offer steady monthly payments for life. For Detroit’s retirees, their pensions were similar to annuities that they funded in their working years and are now being unexpectedly affected by events beyond their control.

This situation offers an important lesson about any investment: No matter how safe an investment appears to be, there is always some degree of risk.

Treasury bills are considered the safest investment. They reach maturity and return your principal within one year or less. For a 90-day T-bill, you earn an annualized rate of return of 0.12%. In some ways, T-bills guarantee a loss when inflation is considered.

Knowing that returns will be low, many investors are increasing the amount of risk they accept to increase the amount of income they receive.

Higher yields are available from long-term Treasuries, which are considered safe because they are backed by the U.S. government’s ability to print enough money to repay all investors. Investors are guaranteed a return of their investment, but like shorter-term T-bills, there is no guarantee that their money will retain its buying power.

High-yield corporate bonds offer the highest income and carry the greatest risk among fixed-income investments. High-yield bonds tend to move in the same direction as stocks when market risk increases. That means investors will face losses in high-yield bonds if interest rates rise or if the stock market drops.

Given the reality that there is risk in any investment, it could make sense to insure your portfolio against large losses.

Put options are an effective form of portfolio insurance. A put option gives you the right to sell a security at a guaranteed price until the option reaches its expiration date. The put will go up in value when prices drop.

In a market crisis, we generally see all markets drop at the same time. Some will drop less than others, but for this “insurance policy” we want to find the biggest losers. Since put options increase in value when prices fall, we want to buy put options on the securities that are likely to drop the most.

During the 2008 bear market, small-cap stocks were among the biggest losers with iShares Russell 2000 Index (NYSE: IWM) down more than 60% from high to low. Put options on IWM could deliver the largest gains in a bear market. Options expiring in January 2015 could return around 10 times their initial investment if we see a similar drop.

iShares MSCI Emerging Markets (NYSE: EEM) also suffered a large loss in 2008, and put options on EEM could be used as portfolio insurance.

If the stock market moves higher, put options will expire worthless. However, when puts are thought of as insurance, the possible loss is simply the price of protection. Allocating 1%-3% of a portfolio to put options on volatile ETFs or stocks could help insure your wealth against large losses.

If you have a pension from a large company, put options on that company’s stock could deliver large returns if the company enters bankruptcy and offset possible losses from your pension.

Insuring against the loss of a pension from a government agency is more difficult. Options are available on iShares S&P National AMT-Free Muni Bond (NYSE: MUB), but puts are unlikely to offer gains that are large enough to offset the loss of a pension. This ETF fell about 12% this year as the market anticipated the bankruptcy of Detroit and traders worried about returns in municipal bonds. MUB fell less than 20% in the 2008 bear market.

There will never be a way to completely eliminate risk in your portfolio, but put options could be a way to reduce the risk to a more acceptable level.