In a recent issue of Fast-Track Millionaire, I introduced my subscribers to a feature our portfolios have not seen until now: a market hedge. And not just any hedge. A high-quality bond might protect you from stock volatility, but it’s not likely to make you a lot of money if the market tanks.

Today, I’d like to tell you a little about it — and why you might want to consider implementing this tool yourself.

#-ad_banner-#While I think abandoning the market is not the answer to recent volatility, this does not mean I want my readers to stand idly by and watch the value of their portfolios decline.

One solution is to start building a portfolio hedge. A hedge, by definition, is something that would make you money in case your main investment won’t. And I believe one such hedge exists. Of course, it’s not fool-proof — there is no guarantee, just as with any investment product, that this particular hedge will act as anticipated. But in this case, history tells us that when the stock market experiences a deflationary shock and dives sharply, this hedge often rallies.

Look at the chart below. On it, I charted the market as represented by the S&P 500 index over the past decade, together with Vanguard Extended Duration Treasury ETF (NYSE: EDV).

That’s because, during the Great Recession, one of the reasons behind the market crash was deflation.

Deflation, or declining prices, is an economic phenomenon that’s bad for stocks. Japan, for instance, has been dealing with deflation for decades, and its stock market has been going nowhere in the meantime.

Deflation hedges, therefore, can often protect against market declines.

And the prices don’t have to decline in order for the deflation hedge to work.

Look again at the chart above. In the 2008-2009 period, when the stock market was crashing, the Federal Reserve was busy saving the economy by cutting interest rates and implementing what is now known as the “near-zero interest rates policy.” The declining interest rates — and the jumping bond prices — also helped this deflation hedge tremendously. With the market down sharply, EDV rallied by nearly as much.

That’s because EDV is comprised of long-dated zero-coupon Treasury bonds, which don’t have coupons but are fully repaid at maturity.

This is easier than it sounds.

EDV Explained
In the Treasury market, these are the Treasury STRIPS (“Separate Trading of Registered Interest and Principal of Securities”) securities. STRIPS are the bonds that are stripped from their coupons, with each part of this package now trading separately. And as a result, the bond, which is called a zero-coupon bond, sells at a large discount to its face value. At maturity, however, the entire principal value of the bond is repaid.

Just as with any bond, the price of zero bonds will always move in the opposite direction of interest rates. Moreover, because zeros don’t pay any interest over their lifetime — they are stripped of the coupons — any market price fluctuation impacts its price much more than it would the price of a conventional, coupon-bearing bond.

Because of this huge leverage, the price of zero-coupon bonds will increase sharply if interest rates fall. This makes them a deflation hedge. This also makes them a good hedge against a stock market decline. If the Fed’s excessive tightening endangers the economy — or even if investors begin to price in such an event — the stock market might turn. In this case, as it has typically been, investors would want to hide in long-term Treasury bonds, benefiting zeros even more.

I’ve been quite happy with since adding EDV to our portfolio on November 28. Here’s a look at how it’s performed over the past few days…

With the market wobbly, and the S&P 500 up about 0.9% since our last Fast-Track Millionaire issue on November 26, EDV has been a champion, up 4.4%. Most of this positive return (3%) came in the past couple of trading sessions, highlighting the hedge’s role as a counterweight to market volatility.

A strong market is likely to result in EDV declining — but that is the nature of any hedge. Meanwhile, I expect EDV to add some stability to the portfolio in case market volatility continues.

Bottom line, while this position may not shoot to the moon, I think it’s a prudent course of action at this time. We hold a lot of interesting companies with big-time potential in our Fast-Track Millionaire portfolio — and I don’t make any addition without a high degree of conviction. And in times like these, when just about everything (including our portfolio holdings) is experiencing a little bit of turbulence, it’s nice to have EDV to smooth out the ride and give us the confidence to hold firm.

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