One of the biggest challenges facing today’s investor who are looking for interest income is the trouble they have finding the best fixed rate bonds without sacrificing any quality. It’s almost like a double negative in today’s market environment. Best rate and high quality are tough to find in the same sentence, and same market.
One of the intentional or un-intentional consequences of what the Central Banks / Federal Reserve is doing with keeping rates as low as they have, is that investors seeking income have been caught in a pickle and are becoming increasingly frustrated with regular savings accounts.
Many investors have turned to Internet savings accounts in an effort to squeeze a little more return from CD or money market funds. Often these online banks can offer higher “teaser” rates to attract money and also because they don’t have the same cost structure or over head found at traditional banks. As compared to regular savings accounts, these can be attractive alternatives if you’re comfortable with the online banking concept.
Unfortunately, too many investors have been enticed into more risky asset classes to get the return they need to maintain the income level in support of their monthly or annual expenses. They began looking for high dividend equities (stocks) they felt were safe, preferred stock, mutual funds and any other investment to capture the yield they long for.
You must realize that investing in higher income producing vehicles comes with risk no matter what you’re told or what you think. This is risk you wouldn’t take if interest rates were 5%, but too many people look the other way at risk until it’s too late.
Risk can be assessed in many ways. One of the easiest ways to think about it is how much income is your investment producing over the “risk free” rate. The risk free rate is simply an investment such as a Certificate of Deposit (CD) or Treasury Bills, Notes or Bonds. If the interest on your investment and the interest on a 1 year CD at the local bank for example has a very big spread between the two, the higher yielding investment may be too risky if you can’t afford to lose any of the principal money invested. For example, if the CD at the bank is paying you 1.5% interest per year to hold your money (that is taxable by the way) and you invest the same money in a preferred stock paying 6% interest per year, then no matter what anyone tells you, that money is at risk and you can lose some or all of it. Especially since investments that act like bonds (preferred stocks) are interest rate sensitive – If and when interest rates rise, the value of your investment will most likely fall, causing significant pain especially if it falls below your initial investment amount.
One of the other areas to be very aware of is high yield bond funds. While you may think that investing money in a mutual fund is one way to diversify, be aware that with bond funds, there is no stated maturity of the fund, therefore in a rising interest rate environment, the fund can and most likely will lose value, and may not come back any time soon. In contrast, if your holding a bond and the value decreases for whatever reason, unless you need the money, you can wait until the bond matures while you collect your interest payments. Mutual funds do not have a stated maturity and therefore are much more unpredictable. High yield bond funds are even more risky and may be worth an entire separate article.
Always invest with vigilance.