It might be time to start thinking about being more weighted toward bonds than stocks. Stocks have been on fire for years but with so many people on Main Street struggling, there seems to be a missing piece to the puzzle. That missing piece is underemployment — people willing to work for lower wages because they can’t find anything else.

Recent reports maintain that the top 1% owns half of the world’s wealth. This has a lot to do with the Federal Reserve’s accommodative monetary policy since 2009, which has inflated bubbles around the world. Stocks have been one of those bubbles. This isn’t sustainable given the fact that the Federal Reserve has $56.2 billion in capital reserves versus $4.3 trillion in debt. (For more, see: 5 Steps of a Bubble.)

Deflation

When everything eventually unwinds and reality sets in we’re going to find out that the Federal Reserve has been fighting against deflation. In a deflationary environment, prices for goods and services come down which means stock prices come down as well. Many people would assume this would be bad news for bonds and if interest rates rapidly increase, then it could be. On the other hand, bonds aren’t a bad place to be in a deflationary environment because the value of the dollars invested in those bonds increase. Of course, you will want to stay away from high-risk/high-yield bonds in this type of economic environment.

It should be noted that cash is another great place to be in a deflationary environment. Just as described above, the value of your dollars will increase. Unlike bonds there is no risk. (For more, see: Deflation: A Two-Sided Coin.)

Muni Bonds

We’re likely heading toward a risk-off environment. That being the case, it would be wise to approach your investments with a conservative mindset. You might want to consider looking into tax free municipal bonds and investment grade corporate bonds. (For more, see: The Basics of Municipal Bonds.)

Tax free municipal bonds are exempt from federal taxes. If you invest in a local bond, state, county, city, or town, they’re also exempt from local taxes. There are exceptions to this rule so be sure to check your local tax laws for confirmation. A tax free municipal bond won’t offer as much interest as investment grade corporate bonds, but they will offer more safety. In 2014, the average default rate for municipal bonds was 0.10%. In most cases, you will need a minimum of $5,000 to invest in a municipal bond but this can vary. Municipal bonds usually mature between one and 40 years.

Corporate Bonds

If you want to invest in investment grade corporate bonds a minimum of $1,000 is typically required. Maturity is often between one and 20 years. The default rate for Aaa investment grade corporate bonds has been around 0.50% over the past several years. Investment grade corporate bonds refer to corporations with high creditworthiness, which means they are less likely to default. By comparison, junk bonds have a historical default rate of 4.5%. They offer higher yield, but they come with a lot more risk. (For more, see: How to Invest in Corporate Bonds.)

Muni Bond ETFs

If you would prefer to own a basket of bond funds for increased diversification and more liquidity consider the Market Vectors Short Municipal exchange traded fund (ETF) (SMB). It tracks the the Barclays AMT Free Short Continuous Municipal Index. AMT free means it’s exempt from the alternative minimum tax. This ETF bond fund comes with a very low 0.20% expense ratio and a 1.19% yield. It has appreciated 1.15% over the past three years. This certainly isn’t anything to get excited about, but capital preservation is the name of the game.

The iShares National AMT Free Muni Bond ETF (MUB) tracks the S&P National AMT Free Municipal Bond Index. It boasts a three-year return of 3.45% and has an expense ratio of 0.25% and offers a 2.70% yield. (For more, see: Top 2014 Muni Bond ETFs.)

The Bottom Line

Investing in the bond market can help diversify your portfolio. Based on the current economic climate it would likely be wise to take a conservative approach. Even if a risk-on environment continues, this approach will still preserve capital while slowly building your net worth.

Dan Moskowitz does not have any positions in SMB or MUB.

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