Thursday, February 26, 2009

Yields Stink - What To Do About It

If you hadn't already noticed, yields on relatively riskless assets are terrible. While the stock market has declined by 50% the decline in interest rates has been, in some case, almost 100%. Treasury money market funds that had been yielding near 5% just 15 months ago are now yielding near zero and are basically closed to new investors. The highest yielding money market I can find is the Vanguard Prime Money Market which is yielding 1.25%, down from about 5.25%, a decline of 76% in yield. Most short-term bond fund yields have also been cut in half or more and yield less than a Total Stock Market Index fund.

A falling stock market hurts, but most people don't depend on it for income and if they are positioned right do not need to touch those funds for many years, allowing them time to recover, not so for fixed income type investments. Fixed income serves two purposes in the portfolio, the first is to provide stability during turbulent times, the second is to provide yield to help the investor earn enough to live. While many fixed income funds failed last year to do either, most of the good one's provide stability, but their yields dropped dramatically.

To give you an example of the effects low interest rates can have on a retiree living off their assets, consider a couple who had $100,000 and was earning 5.5% in a two year bank Certificate of Deposit (back in 2007). They would be receiving $5,500 per year in income. The bank CD is now coming due and interest rates for a new two year CD are around 2.5% (if you're lucky), which yields only $2,500 per year. This represents a drop in income of 55%. Devastating.

So what do you do?

Most people start looking for higher yielding investments and with that higher yield comes higher risk. Many start attending "seminars" put on by brokers who advertise high rates but are really just selling snake oil, others buy "CD's" from offshore banks like Stanford Financial, believing that they are protected. The reach for yield becomes a dangerous game that rarely ends well even for those who purchase relatively safe bond funds. What most people don't realize is that when interest rates go up, bond prices go down - thus you incur losses. Now you've been hit with a double whammy, lower interest rates and less money. If you weren't spending this money, the higher rates would eventually offset the losses - a rising interest rate environment is actually good because your income starts rising.....its the short term pain that you must endure of principal loss that most people that understand.

Let me give you an example:

The money market fund that was paying you 5% is now paying you .5% (one-tenth of the previous rate) and you decide to stash your money into an Intermediate Term Investment Grade Bond fund that is now paying 6%. Seems like a good trade, you earn more money while all those poor schlubs are getting next to nothing. What most people don't understand is that this bond fund will react negatively to rising interest rates (eventually interest rates will rise). In fact, a 1% increase in interest rates will equal a 5% decline in principal. Furthermore this fund is very different than a money market or FDIC Certificate of Deposit, it has Credit Risk. Credit Risk is simply the risk that one or more of the bonds in the portfolio will default. But its Investment Grade, that won't happen right? Maybe, maybe not - but do you trust the rating agencies who gave these bonds Investment Grade status? I certainly don't. So you are getting your yield, but at what risk. If two years from now interest rates rise by 2% (let's say we have inflation and the fed decides to fight it by raising rates) your $100,000 falls to $90,000 and this assumes no defaults. If this is an acceptable risk to you, then go for it. I'm not inclined to bite just yet with so much incertainty. For those who want to take risk, this trade may pay off well - but remember, for individuals the goal of fixed income is to provide stability in the portfolio, you don't need your bonds sinking at the same time as your stocks.

So what is my advice? This is tough, there is no good immediate answer. What I'm advising my taxable clients to do is to stay short and not take on much if any credit risk. It means sacrificing yield in the short term, but I believe it will end up saving them money in the longer term. Bank CD's are reasonable alternatives if you can get a good rate, savings accounts that offer higher yields and FDIC protection are reasonable right now and I also think that Treasury Inflation Protected Securities offer a reasonable return over a five year period (though with some fluctuation risk).

I'm going to list some Vanguard Funds and their current yields as well as the latest rates from Bankrate to give you an idea of the current market environment for yield.

Treasury Money Market .27%
Prime Money Market 1.19%
California Tax Exempt Money Market .53%
Short Term Bond Index 2.40%
Short Term Federal 2.15%
Short Term Investment Grade 4.98%
Short Term Treasury 1.22%
GNMA (Ginnie Mae) 4.69%
High Yield (Junk Bonds) 10.66%
Intermediate Bond Index 4.56%
Intermediate Investment Grade 6.06%
Intermediate Treasury 2.50%
Total Bond Market 4.48%
Inflation Protected 2.43%

Bankrate overnight CD Rates

6 Month 1.66%
1 year 2.15%
5 year 2.68%

If I can help you better understand interest rates and different fixed income investment options please let me know.

Scott Dauenhauer CFP, MSFP, AIF