By Author of Life, Investments, Everything Blog
We are in a persistent low interest rate environment and this shows no obvious signs of changing in the near future. Many people who have been accustomed to receiving 5% and higher yields on CDs, treasury bonds and other “safe money” instruments are now faced with increasing maturities and have to decide what to do with the funds.
If you have older instruments maturing, there are not many palatable choices. Investors really have two choices:
Before one decides which of these two paths to take, some soul searching is in order:
The answers to these questions will ultimately drive the decision you make. If you simply cannot accept the low returns currently offered by “safe” instruments, you will have to take more risk in order to make your minimum return. Conversely, if you cannot accept any risk to the principal of these funds, it may be preferable to accept the very low returns offered by “safe” instruments even if you have to spend down some of the principal.
I would suggest a mix of online deposit accounts, 5 year CDs with acceptable early withdrawal penalties, and perhaps some Series I savings bonds (I bonds). Online savings accounts offer bulletproof safety (as long as you stay within FDIC insurance limits of $250,000), instant liquidity, and the ability to earn more if interest rates rise. The major downside is that these types of accounts offer the lowest yield even if you shop around. The best way to minimze the damage is to pick one of the most competitive banks for online savings accounts. At the time of writing this, Kiplinger’s lists Discover Bank as the highest yielding online savings account of .90%.
Some or all of your “safe” money could be put into longer term instruments provided that you still have the option of cashing out without taking a serious beating if rates rise. For example, a 10 year treasury is a terrible idea for individuals unless you are convinced rates will continue falling and stay very low for years. If rates increase a couple of percent, a 10 year treasury would lose something between 10 and 15% depending on how long the rate rise takes. This is unacceptable for “safe” money. A far preferable alternative is something like a 5 year CD with a modest early surrender penalty. For example, www.penfed.org currently offers a 5 year CD with a yield of 2% and an early surrender penalty of 12 months worth of interest (2% of the CD principal). Such an instrument is as safe as a treasury bond, offers three times the interest of a 5 year treasury, and allows you to liquidate for 2% of the CD if rates rise or you suddenly need the money. However, if you choose to buy a longer term CD read the fine print carefully. Early withrawal penalties vary very widely between banks (some offer no early surrender option at all, common with broker-sold CDs), so look for a CD with a penalty of no more than 12 months’ worth of interest.
Another alternative may be an I bond sold exclusively via www.treasurydirect.gov. An individual may buy up to $10,000 a year in I bonds. These savings bonds cannot be cashed in for 1 year after the time of purchase, after which they can be cashed in for a penalty of the prior 3 months’ worth of interest (or no penalty after holding the bond for 5 years). I bonds are attractive as a short term “safe” money instrument because they sometimes offer much more attractive yields than the alternatives (such as a savigs account or 1 year CD), are as safe as treasuries, allow liquidation at a nominal penalty, and interest earned on your bonds is tax deferred until you cash them in. The downsides of I bonds are zero liquidity for a year, the $10,000 per person annual purchase limit, and the fact that the interest rate changes every 6 months. I bonds bought throught April 30, 2012 will yield 3.06% for the first 6 months after purchase, but beyond that the rate may be as low as zero. Compared to an online savings account, a I bond at the current rate which earns 3.06% for the first 6 months and nothing for the following 6 months would still be attractive because the all-in 1 year yield would be 1.53%.
However, I would suggest that if this money is still supposed to be at least moderately “safe,” it would be wise to keep a portion of your funds in one of the “safe” options above and boost yield with the rest of the money invested in something less risky than equities. Possibilities for yield-boosters include investment grade corporate bonds, higher grade junk bonds (BB-rated) such as those typically owned by Vanguard’s high yield bond fund (symbol VWEHX), merger arbitrage funds like MERFX or ARBFX, or closed end funds that own a variety of fixed income instruments and trade at a 5% or greater discount to NAV (I like JQC, as detailed here). In other words, I believe the most sensible approach is to try to generate the yield you need while taking the least amount of risk you must accept. You could indeed go out and buy a bunch of high volatility individual equities, but that is very far from the concept of safe money and probably unwise.
I keep about 10% of my portfolio in “safe” instruments. I consider this to be part of my fixed income allocation, but it is also a way to generate gobs of cash if the commode hits the windmill. If need be, I could cover the bills for a good 2 to 3 years with these funds. Trying to balance the need for yield with liquidity, I have this money allocated 40% to cash, 10% to I bonds, and 50% to CDs purchased in the last few years. As my older, higher rate CDs mature, I will either put them into new 5 year CDs with modest surrender penalties, or I will put the funds into I bonds.
You may be wondering why I keep putting the word “safe” in quotes. While most people think of safety in terms of the stability of principal, I think it is important to remember that potential principal losses are only one form of risk. ”Safe” instruments like CDs really only offer this narrow form of safety while continuing to expose investors to other forms of risk. Chief among these is inflation risk, which is usually the bane of conservative investors. Be aware of ALL the risks and hedge or accept them them as you will, but don’t pretend they do not exist.
As always, consult your advisor if you have one. Be careful and do your own due diligence. Always read the fine print. You can lose money on this stuff.
Disclosure: Lng CDs, I bonds, MERFX, ARBFX, JQC.