It may be the most-asked question in personal finance: “With interest rates on certificates of deposit so low, what better investment is there for boosting my income?”
There are ways to get higher returns. But getting those higher returns entails taking some risks that CDs don’t carry.
Of course, a play-it-safe strategy has a risk, too. As longtime investors in CDs have found, there is reinvestment risk-the risk that when a CD matures, you’ll have to reinvest at an unattractively low rate.
“People who are savers have to get beyond the CD mentality,” said Steve Janachowski of Brouwer & Janachowski, a San Francisco investment advisory firm specializing in no-load mutual funds. “There is nowhere a saver can go right now and be safe by sticking with fixed-income investments. They have to have a little more balance to their portfolio.”
Investors who need higher current income must take other risks. They must tie up their money for longer periods, or invest in securities with a higher chance of default, or invest in securities whose market values can decline. Including stocks.
Good move for retirees
Taking a moderate amount of additional risk is sensible for retirees and others who need higher current income than they’re getting from CDs and who want a chance of beating inflation. Balance is the key.
One balancing method is to build a “ladder” of different maturities. This can be done with CDs by dividing money among certificates of varying maturities ranging from, say, six months to five or seven years. This will produce higher income than holding only short-term CDs.
More income can be gotten by using the same laddering technique with bond funds-mutual funds that hold various kinds of government or corporate bonds.
Bonds are IOUs, issued by a government or a company that promises to pay interest and to repay the borrowed money when the bond matures on a specific future date. Unlike CDs, bonds are not covered by federal deposit insurance and the principal value of bonds or bond funds will fluctuate.
In general, interest rates paid on bonds rise along with the risk of default. U.S. Treasury bonds are considered the safest. Corporations are rated for their financial strength by analysts, and the yields on corporate bonds rise as the financial strength of a company declines.
Another general rule is that the further a bond is from maturity, the higher interest it pays, as compensation to the investor for the risks of higher inflation and future repayment problems. Price fluctuations of bonds also increase along with the length of time until the bonds mature.
If market interest rates surge 1 percentage point, the market value of a two-year Treasury note will fall by 1.88 percent, while a five-year Treasury note will lose 4.25 percent of its value, a 10-year Treasury loses 7.12 percent, and a 30-year Treasury bond loses 11.6 percent of its market value.
Conversely, a fall in interest rates causes the market value of notes and bonds to go up, with the size of the gains rising along with the bonds’ lengths to maturity.
A conservative investor can manage the interest-rate risk by splitting his money among funds that invest in bonds of different maturities. Mutual funds range from money-market funds, which pay the lowest interest rates and whose principal does not fluctuate in value, up to long-term bond funds whose holdings have an average maturity of 20 years or more.
A person with $20,000 split equally among CDs maturing in one, 2 1/2, five and seven years could have gotten an average yield of 3.94 percent recently at one large Philadelphia bank. That would produce interest of $788 a year, or $65.66 a month.
One could get at least $986 a year, or $82.16 monthly, by splitting $20,000 evenly among four no-load mutual funds: a short-term corporate bond fund; a medium-term Treasury bond fund; a long-term, high-quality corporate bond fund; and a balanced fund, one that holds stocks and bonds.
Market value rises
If interest rates were to fall, the interest paid on the bond funds would slowly decline, but the market value of the funds would rise. If interest rates were to rise, the market value of the bond funds would decline, but interest income should gradually increase.
The balanced fund provides current income plus a chance for higher total return, since stocks tend to outperform bonds over long periods.
