Have you insured yourself against the coming crisis?

Interest rates are crucial in determining what happens to your investments. If rates rise, it'll unleash downward forces on everything from property to shares and bonds. And you need to be prepared for that.

Last week I discussed the merits of the Co-operative 5.5555% perpetual bond as an insurance against such a fallout. And since then the subject of whether this bond is good insurance has been raging.

It's such a pertinent debate that I think we should spend a few moments having a good old think about it. Where do you see interest rates going? And how have you insured yourself against any adverse movements? These are probably the most important questions you can answer right now.

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So allow me start with my thinking on this

The beauty of the Co-op 5.5555%

A bond ties you in to a fixed rate of interest. Right now that could be a Tesco bond paying 5% fixed for seven years. But if inflation suddenly strikes, then you should expect rates to go up too. And suddenly that bond won't look so good. While other savers will start to enjoy higher interest rates, you'll be locked into a bad rate.

The beauty of the Co-op 5.5555% bond however is that after 2015, this bond will become a Libor-tracker. What does that mean?

Well I'm sure you are familiar with Libor by now. But if somehow you missed the coverage of the scandal, the London interbank offered rate is basically the average interest rate at which banks lend to each other. (You can view a great video on Libor and why it matters here.) If inflation rises, so should Libor. And so the Co-op bond offers good insurance for your portfolio.

But many readers point out that this bond could be bad insurance against rising inflation. Here's why

Will my bond protect me?

Back in the old days when I formally studied economics, Keynesianism was out of fashion. It was considered kind of absurd that the state should meddle too aggressively in the economy. Monetarism was in. The idea was that the authorities should simply control money supply and interest rates (and so keep inflation down). Other than maintaining a sound currency, government should keep its snout out.

During the eighties the Thatcher and Reagan regimes showed the world how monetarism was supposed to be done. If inflation went up, interest rates went up. That's how modern central banking was supposed to work.

Fast forward to today and we see that the authorities have reverted back to the old Keynesian texts. Government spending is back in and the link between inflation, and inflation-quelling interest rates has all-but disappeared.

So here's the crux of the matter. If inflation can go up without interest rates following, then what use is my Libor tracking bond?

Good point!

In fact, it's one reason why I'm such a firm believer in bonds. Over the coming years I expect to see interest rates pegged to the floor. Frankly, if rates were allowed to go up to where they should be (say 5%, or 6%) the western financial system would implode.

Instead the central planners continue to meddle and they continue to hold rates artificially low. At some point there's a big risk that this great delusion will fail. And how it fails will determine which investments do best.

An all out breakdown of the financial system should favour precious metals (yes, got that covered!). A protracted stagflation may be okay for decent defensive shares (yep... got them too).

But a return to sound monetarist policies should favour my Co-op bond. If interest rates go to where they should be, it would surely bring on the mother of all depressions. Shares would struggle. Dividends on shares could get slashed. But I firmly believe my Co-op bond will stand tall.

And that's why I like it. This bond offers me genuine diversification. Too few investors are genuinely diversified. Diversification is not just about lots of different investments in your portfolio. It's about owning investments that react differently to different outcomes.

Don't let your bias ruin you

I love looking at investor portfolios. To me it's fascinating. Many people genuinely think they're well diversified, but when you look a little closer you notice some biases that sap diversification.

I saw a portfolio recently that had bonds, shares, property and cash. All well and good you may think. But upon inspection I noticed a heavily biased portfolio. The bonds were index linked. The shares were largely aimed at resources (oil and miners). Then there were a couple of property REITS and cash.

Do you see how this guy isn't, in fact, very well diversified? He's clearly worried about inflation and rising interest rates... but he could get screwed in a deflationary bust.

That's why you need to stop thinking about specific outcomes. Try not to get too hung up on deflation, inflation, or even stagflation. These biases have a nasty habit of sapping your portfolio of diversity. What you want is a portfolio that can react positively to different outcomes over different timescales.

I don't have to believe that my Co-op bond will leave every other investment for dust. But I strongly believe that in certain circumstances, I'm going to be very glad I've got it with me. I don't know which of the 'flations we're going to be fighting, so I'm packing a wide selection of armaments.

And anyway, this Co-op bond may even prove its worth before the real fighting starts. Come the end of 2015, it could provide a wonderful payout. For a reminder of why, take a look at last week's article. And be sure to let me know how you are preparing for rising rates in the comments below.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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