How to Invest During a Recession

If that describes you, you're probably a bit gun shy about the stock market — especially since recession predictions are proliferating faster than reality TV shows these days.

But an economic slowdown or even a full-blown recession don't necessarily mean it's time to cash in your remaining stocks and hide your money under the mattress. Instead, this should be a time to review the lessons you learned from last year's market misery and make the necessary adjustments to your long-term investment strategy.

We talked to some financial planners for their recommendations of what to do now. Here's what they had to say.

Bond Funds
Now is an especially good time to consider bonds, some planners say — perhaps for as much as 20% of assets. "There are a lot of reasons for investors to reconsider their stock-to-bond balance," says Harold Evensky, a financial planner and principal in the Coral Gables, Fla., money-management firm Evensky Brown & Katz.

Evensky recommends putting money into an investment-grade corporate bond fund rather than buying U.S. Treasurys, the gold standard of fixed-income products. Why? Even after the Federal Reserve's surprise half-point interest rate cut last week, corporate bonds remain an attractive alternative for return-hungry investors looking to avoid some of the risk associated with stocks. The current average yield on a five- to 10-year corporate bond is 6.5%, a full 1.5 percentage points above the 10-year U.S. Treasury. The returns are even greater on 20-year investment-grade corporate bonds, which currently carry an average yield of 7.48%, according to Moody's Investors Services, the bond-rating company.

Of course, those higher yields reflect the higher risk inherent in corporate debt compared to U.S. Treasurys. But even though the percentage of corporations defaulting on their debt obligations is on the rise as the economy slows, the risk to investors is particularly low for investment-grade bonds. Moody's says the default rate on these products is less than 1%, compared with the 7% default rate on much riskier high-yield or junk bonds. The risk associated with investment-grade bonds is further minimized in a broad-based corporate bond fund. "If you hold an investment-grade bond fund, your exposure to defaults is pretty low," says John Puchalla, a Moody's economist. "But if you start buying individual bonds, you start raising that risk."

Investors with a greater risk tolerance — and much deeper pockets — may even want to consider buying into a junk-bond fund. Recent history has shown that junk-bond investors have earned their best returns the year after the junk-bond market bottoms out. In 1991, while the nation was mired in its last recession, the junk-bond market produced an eye-popping 34.6% return on investment (which includes both the interest paid on the bond and the change in its value), according to Moody's. The year before that, when the recession was just beginning, junk-bond investors lost 4.3% on their investments. Some are predicting a similar spike in the junk-bond market in 2001, because the average junk-bond investment lost some 4% last year and the Fed has begun slashing interest rates, just as it did in 1991.

"Paradoxically, the returns during a recession are higher than during expansions for the high-yield [junk bond] market," says Martin Fridson, Merrill Lynch's chief high-yield strategist. "Interest rates start to come down during a recession, and all bond [prices] tend to benefit from that."

The impact of declining interest rates is magnified on the junk-bond market because high-yield bonds carry much higher rates than other kinds of bonds. Declining rates make those high yields that much more attractive, which tends to raise the price of the bonds that pay them. The trade-off, of course, is that junk bonds have higher default probabilities — a particularly scary thought during a recession. But even though the default rate on junk bonds is 7% and rising, most don't see it surpassing the 10% default rate of 1991. That's why Fridson recommends that individual investors stick to broad-based, diversified junk-bond funds.

Still, given the risks associated with junk, most financial planners say the average bond investor — especially one with a smTexter wallet — shouldn't stray from investment-grade corporate debt.

Exchange-Traded Funds
For those investors itching to play the stock market again, planners say now isn't the time to try to pick hot stocks. Instead, they suggest buying shares in several exchange-traded funds, or ETFs — stocks that track the performance of a major market index such as the Dow Jones Industrial Average or the Nasdaq 100, or are based on actively managed mutual funds. That way, they can participate in any early rally in stocks without being overly exposed to any single company's poor earnings performance. In the past few years, ETFs have grown in popularity with individual investors because they're cheaper and easier to invest in than traditional stock index funds. "ETFs are a very effective investment vehicle," says Evensky. "We use them a lot, and we think they make a whole lot of sense because they are inexpensive and very marketable."

Money-Market Accounts and CDs
Finally, financial planners say that in a recessionary environment, investors shouldn't be ashamed to keep some extra money in an interest-bearing money-market account — especially if they're investing money they'll need fairly soon. Louis Stanasolovich, founder and president of Pittsburgh, Pa.-based Legend Financial Advisors, says investors shouldn't expect to get rich off the 4% annual yields offered on most money-market accounts — but at least they're guaranteed to make some money. He also suggests investors stash some money in six-month or one-year bank certificates of deposit, which on average pay a 2% higher annual yield than a money-market account. (Investors can find the best yields on bank CDs and money-market accounts at www.bankrate.com.)

The bottom line, says Stanasolovich, is diversification. And that's a valuable lesson investors should keep in mind even when stocks are again heading due north.