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By Jeremy Glaser | 06-26-2013 01:00 PM

Special Report: Investing in a Volatile World

Morningstar's top strategists discuss their tips for investing in a rising-rate environment, where equity values lie, and some of their favorite investment ideas right now in this special midyear roundtable.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Welcome to our Midyear Strategist Roundtable. We are going to talk with several Morningstar newsletter editors about how they are thinking about investing in a rising-rate environment, their cash stakes, and also the biggest surprises so far in 2013.

I'm joined with Josh Peters, director of equity income strategies and also the editor of Morningstar DividendInvestor; Matt Coffina, editor of Morningstar StockInvestor; Sam Lee, editor of Morningstar ETFInvestor; and Russ Kinnel, who is our director of mutual fund research and also the editor of Morningstar FundInvestor.

Gentlemen thanks for joining me.

Russ Kinnel: Good to be here.

Josh Peters: Good to be here.

Glaser: One of the big pieces of news recently has been the runup in interest rates and some of the turmoil in the bond market. How much longer do you think that interest rates could keep rising? Do you expect this to be a trend that’s going to continue?

Kinnel: I mean certainly there is a potential for it to run longer. We're really still in the early stages of [Fed officials] just talking about tapering their [bond-buying] efforts at some point. We had a very long bond bull market, and so we are just kind of in early stages. So it's hard to predict where that stops.

Glaser: So what does that mean for your fixed-income holdings? Is this a time to kind of really reassess your entire bond position? What kind of categories do you think are going to do better or worse in this environment?

Kinnel: I think on the first question at least you want to talk a look and see how your bond fund has done in the last month and half because that at least is going to give you some sense for how much interest-rate-risk was there. I think now it means you've got some better yields. Yields are still not great, obviously. We have a long way to go before they are really attractive, but they are better. And there might start to be some interesting opportunities. For instance in high yield you are seeing yields that are little more respectable these days.

Sam Lee: Yeah, I'd like to chime in. You have to put the interest-rate rise in historical context. About 2.6% yield on the 10-year Treasury is still extremely low by historical standards. And I think it's unlikely that interest rates will shoot up 5% to 10% anytime soon because right now the economy is deleveraging. So, households have a lot of debt. The government has a lot of debt. Historically, in periods of deleveraging, the central bank and the government tend to collude to keep long-term interest rates down, and that eases the burden of paying off debt service.

So, the U.S. government did that after World War II. They amassed a huge pile of debt far in excess of what we have right now, and they managed to pay that off by suppressing interest rates for very long time. So, there is no reason why they couldn't do that. They can't keep on continuing to do that.

That said, bonds are a very unattractive asset class. You're going to get the yields in the best-case scenario. You will probably get something a lot worse in a more reasonable scenario should interest rates normalize over time. So, if you're heavy in bonds, going long term is probably a really dumb idea. Warren Buffett says the long-term government Treasury is the dumbest investment you can make right now.

Conversely, if that's dumbest investment, then the smartest investment is basically shorting it. You can't really short it easily because there are a lot of issues of path dependency, so you can get shaken out of your position. But a 30-year mortgage at a fixed rate of even 4% right now is still very, very attractive deal. After the mortgage interest-rate subsidy and inflation, your real cost on that loan is probably very low, and you have a natural inflation hedge in that asset class. So, taking a 30-year bond, if you are very creditworthy borrower--so don't go out and overleverage your portfolio--but if you have the opportunity and the means and the need to own a house right now, take out a mortgage.

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