Six income-lifting strategies in a low interest-rate environment
Author: Stephen Ahern
The Federal Reserve has stated that it plans to keep short-term interest rates “exceptionally low” until at least mid-2013. That’s music to the ears of borrowers but bad news for savers, who are saddled with historically low rates on savings accounts, certificate of deposits (CDs), money market funds and U.S. Treasuries.
What can you do to boost your returns?
Strategies to consider
Here are six possibilities, roughly in order of increasing risk:
1. Online savings accounts. You can boost your income modestly but safely by opening an online savings account. The annual interest rate for a traditional, brick-and-mortar bank’s checking and savings accounts generally is 0% to a paltry 0.10%. In contrast, an online savings account might pay as much as 1% or more.
Higher rates and the $250,000-per-depositor FDIC protection offered by most online banks make this a painless and virtually risk-free way to make your money work harder. But if you’ll be leaving one or more accounts at your traditional bank, consider any possible fee increases or interest rate reductions it may impose because of your lower balance there.
2. Longer-term CDs. If you’re willing to deposit your money in a three-year CD, you can earn about 1.5% as of this writing, and close to 2% for a five-year CD. However, be sure you know the penalty for early withdraw. In many cases, this penalty is modest enough not to be an obstacle if you’re hesitant to “lock up” your money.
At one online bank, for example, the penalty for early withdrawal on any CD is 60 days of interest. For an account paying 2% annually, such a penalty amounts to 0.33% of your principal (just $3.30 per $1,000). If interest rates increased significantly after you bought such a CD, you could withdraw the money before your term was up and reinvest it at the higher rate.
3. Short-term bond funds. A short-term investment-grade bond fund at one well-known fund family paid 1.74% annually and had a 10-year average annual return of 4.11% as of this writing — well above the lesser rates offered by money market funds. Understand, though, that such a fund is subject to both interest-rate and credit risks.
If interest rates rise, bond fund prices generally fall — though the damage typically is more muted in funds that hold securities with shorter maturities. Credit risk can be a factor if the economy takes a turn for the worse. In that case, a flight to quality can hurt debt perceived as risky, which sometimes includes corporate bonds with investment-grade credit ratings.
4. GNMA (AKA “Ginnie Mae”) funds. These funds invest in government backed Mortgage securities. They backed by the full faith and credit of the U.S. government and typically offer higher yields than U.S. Treasuries. As of this writing, a number of these funds are paying in excess of 3% annually. Be aware that the government guarantee applies only to the securities (mortgages) purchased inside a GNMA fund, not to your investment into the fund itself. Money invested in a GNMA fund is at risk like any other mutual fund investment, due to movements in interest rates, among other factors.
5. High-yield bonds. Also known as junk bonds, high-yield bonds are lower-quality corporate debt. There’s no doubt that yields in this asset class can be tantalizing. Even during good economic times, junk-bond yields normally are several percentage points higher than those of comparable Treasuries.
Look out, though, if investors begin to worry about whether corporate profits can support those debt payments. Junk-bond prices can quickly fall. A good time to invest in this asset class generally is when economic activity is strengthening.
6. Dividend-paying stocks. There are several reasons to consider this category. Corporate balance sheets generally are in solid shape, and the valuations of the shares of many large, dividend-paying companies have fallen near multi-decade lows.
Additionally, many of these firms have a long history of boosting their dividends annually, increasing shareholders’ income. There’s also the potential for capital appreciation. That said, even high quality stock prices can fall, so be forewarned.
Diversification rules!
Remember yield is only one component of return on a portfolio and that “total return” on a portfolio is typically better and a more important focus than the yield itself. It is better to have a more diversified approach to investing, seeking long-term total returns. Gains can be taken from stocks, bonds, etc. when the portfolio is rebalanced so that you get additional tax advantaged income and you are not reliant solely on the yields in a low rate environment like the current one.
Before reaching for just higher yields, it’s important to be clear about your priorities. Your advisor can provide assistance in helping you find a mix of investments that suits your risk tolerance and income needs.
Tags: buy and hold, CFP, CPA, Financial Planning, Investing, investment planning, investments, long-term investing, Stephen Ahern, wealth management
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