(MONEY Magazine) – Q. I just read Peter Peterson's book about the deficit, Running on Empty. Now I'm worried that Washington is digging the country into a fiscal hole. How can I protect my portfolio? And what should I tell my daughters, who look to me for investment advice? BOB BURESH -- ST. PAUL
A. Deficits are an enormous problem, but they probably won't sink your portfolio in the next few years. There is no proven link between rising deficits and poor stock markets, and in the short run deficit spending can be good for the economy and the market. Stocks rose more than 25% in 2003, 1985 and 1975, all years in which the federal deficit reached new heights.
It's a slightly different story for your bondholdings. The bond market reacts none too happily to rising deficits. Expect to see bond prices fall over the next few years, with the longest bonds suffering most. That means you're best off in a shorter-term bond fund like Pimco Low Duration (800-426-0107).
The burden of the deficit will fall more heavily on your daughters. Continued deficit spending will probably lead to higher taxes down the road. The best advice you can give them is to invest more now, and even to take some chances, such as investing in growth and tech stocks. Adding risk to your portfolio can boost returns if you can wait out the ups and downs. And your kids may need all the extra cash they can get.
Q. Recently MONEY said that with yields at historic lows, bonds will likely be lousy performers. Does that include munis? JERRY MASSENGALE -- DALLAS
A. Municipal bonds are a better bet right now than Treasuries or corporates. Here's why: Munis are likely to be in short supply in the next few years, as the rising economy helps shrink local budget deficits. (States and cities seem to be in better fiscal shape than the feds.) Consequently, munis will probably fall less than Treasuries and corporates as interest rates rise. What's more, municipal bond income is tax-free on a federal level, and often exempt from local taxes as well. In Texas there is no state income tax, so you don't get as big a tax break. Still, in late November, the average 10-year Texas municipal bond was yielding 3.7%, which was higher than the post-tax 2.7% for a 10-year Treasury bond. Bill Gross, one of the savviest bond fund managers around and the chief executive of Pimco, has recently been investing his own money in muni bonds. A great way to get into munis is the Vanguard Intermediate-Term Tax-Exempt Fund (800-851-4999), with an expense ratio of just 0.17%.
Q. Is there a mutual fund out there that follows the "Dogs of the Dow" strategy? STEVEN R. LOSA -- MENDON, VT.
A. The Dogs strategy calls for investing in the 10 highest-yielding stocks in the Dow Jones industrial average. Since dividend yields rise as prices fall, the idea behind Dogs is that you are constantly putting money into relatively undervalued stocks. The fund that most closely follows that strategy is Hennessy Total Return (800-966-4354). But Hennessy has annual expenses of 1.27%, which seems high for a fund that follows a very simple strategy. A better choice is T. Rowe Price Equity Income (800-638-5660), which buys a diversified portfolio of large-cap stocks with high dividends. It has an annualized return of 5.5% for the past five years vs. 2.3% for the Hennessy fund. And its expenses are well below Hennessy's.