Raw Finance

Today, I want to discuss in detail some investment alternatives to the stock market, namely, fixed-income investing.  Such investments include: certificates of deposit (CDs), money market accounts, municipal bonds, treasury bonds, inflation-adjusted bonds, and annuities.

These are generally referred to as “fixed-income” investments because the buyer of the instrument receives a fixed rate of interest for a fixed period of time in return for his or her investment.  Fixed-income investing is considered to be safer than stock market investing because, generally, one will not lose one’s initial investment.  However, this does not mean that these investments come with no risk.  First, I will discuss the various risks that are generally inherent in fixed-income products, and then I will review the various products and strategies for mitigating the risks.  I will also provide links to other information providers for more detail.

RISK

Interest Rate and Inflation Risks:

Interest rate risk and inflation risk are similar but not the same (for a quick refresher on inflation see a previous post here).  Interest rate risk is a form of opportunity cost.  Once an investor purchases a CD or bond, he or she has locked in a certain interest rate for a fixed period of time.  If interest rates increase during that time, the investor has lost out on the opportunity to earn the higher rates.

Interest rates tend to rise during inflationary periods.  When the money supply increases to a point where it puts upward pressure on the prices of commodities, goods and services, the Fed tends to raise interest rates in order to slow the pace of borrowing.  This usually has the desired effect of decreasing the money supply.  It also has the effect, generally, of raising interest rates on fixed-income investments.  This is how inflation can affect interest rate risk.  However, inflation is also a risk of its own.

For example, let’s say an investor buys a bond with a $10,000 par value at 5 percent interest that will mature in 5 years at a time when the consumer price index is rising at a 2 percent rate.  Thus, discounting inflation, our investor earns a “real” interest rate of 3 percent per year on his or her investment, assuming that the increase in the consumer price index remains at 2 percent.  Of course, as the prior year has taught us, nothing is guaranteed and change is the only constant.  So, to add a dose of reality to our scenario, let’s assume that over the final 4 years of the bond’s life, the consumer price index rises at an annual average of 4 percent.  The real interest rate on the bond drops to 1 percent in each of the final four years until maturity.  That is inflation risk.

Additionally, with respect to bonds, interest rate risk has an impact the market value of bonds.  When purchasing a bond, be it a corporate, treasury, or municipal bond, the investor may not always pay exactly the par, or face, value of the bond.  The reason is that the bond market sets the market price at a discount or premium to the par value of the bond based on the maturity date, interest rate, and economic expectations.  Therefore, even once the investor has purchased the bond, the value of the bond will continue to fluctuate until maturity.  Interest rates and bond prices move in opposite directions of each other.  If interest rates rise, then the market price of the bond will drop.  The investor may sell the bond before reaching the maturity date, but, by doing so, the investor may incur a gain or loss on the value of the bond.  If the bond is held to maturity, the investor is guaranteed to be repaid the par value of the bond, regardless of what price the investor originally paid.

Credit Risk

Credit risk refers to the likelihood that the bond issuer will completely pay the principal and interest on the bond.  Because CDs and money market accounts (again, not money market funds) are maintained by FDIC-insured financial institutions, there is virtually no risk of non-payment.  With bonds there is a risk of default.  The amount of risk varies depending on the issuer, and the risk is generally priced into the interest rate and market value of the bond.

Among the three general categories of bonds (treasuries, municipal, and corporate), U.S. Treasury bonds are considered to have the least credit risk (and are therefore the safest) because they enjoy the full backing of the U.S. government.  That is why during periods of stock market instability and/or economic uncertainty, investors around the world line up to by U.S. Treasury bonds.  It is a good thing, too, because that is how our country finances its ever-growing debt.  Next on the credit-risk spectrum are municipal bonds.  These are debt instruments issued by state, county, city and other local government authorities to fund various activities.  Again, because these are backed by tax-payer dollars and have a low default rate, municipal bonds are generally considered to be safe.  Like any other investment though, the lower the risk, the lower the reward.  So, government-backed bonds generally carry a lower interest rate than corporate bonds. Corporate bonds are debt instruments issued by individual corporations.  Issuing bonds is an alternative to selling equity in the stock market for corporations that need to raise money for their activities.

To assist investors in identifying the risk related to any bond, there are three agencies that assign ratings to bonds: Fitch, Inc., Moody’s, and Standard & Poor’s (S&P). However, these ratings may be called into question after the revelation offered by an S&P employee that the company would rate a securities deal even if it were “structured by cows.” (See full story here).  I prefer to follow Fitch’s ratings, as they seem to have a good track record.  Bonds are generally classified as investment grade or sub investment grade, also known as high-yield or “junk” bonds.

Call Risk

Some bonds have a “call” provision that allows the issuer to call, or repay, the bond early.  This typically occurs in a falling interest rate environment.  The issuer can save money by repaying its callable bonds and issue new bonds at lower interest rates.  This puts the bond investor in the position of losing the income stream from the bond and being forced to reinvest in a new bond at a lower interest rate.

PRODUCTS AND STRATEGIES

Certificates of Deposit and Money Market Accounts

Both certificates of deposit and money market accounts (not money market mutual funds) are time deposits offered by financial institutions and are generally covered by Federal Deposit Insurance Corp. deposit insurance. The FDIC insurance limit was recently increased from $100,000 to $250,000 (full details here).

Under a certificate of deposit, the depositor agrees to place a certain amount with the bank for a definite time period, usually from as little as 3 months to as many as 5 years.  The bank agrees to pay the depositor a fixed rate of interest on the deposit amount for that period.  The depositor cannot remove the funds from the CD during the agreed-upon time period without paying a substantial penalty.

Money market accounts are similar to certificates of deposit, but offer more access to the deposited amount. For current money market account rates, please click on the following link to Bankrate.com.

For a current outlook on the value of CDs, please click on this link to Bankrate.com.

Strategy

CDs are not exposed to credit or call risk.  However, inflation and interest rate risk may diminish the return on one’s CD investment.  For larger deposits, one way to mitigate these risks is by use of a CD ladder.  One creates a CD ladder by purchasing several CDs of varying maturities and spreading the total investment evenly among them.

For more detail on creating a CD ladder, please click on this link and/or this link to view relevant material at Bankrate.com.

Bonds

I have already identified the three general categories of bonds (treasury, municipal, and corporate) and their relative risk factors.  Bonds are subject to all types of risk: interest rate, inflation, credit, and call.  Credit and call risk is relatively easy to mitigate.  One need only choose treasury bonds or, among municipal and corporate, the highest rated bonds that have no call provisions.  The downside to doing this, of course, is the acceptance of a lower interest rate in return for the lower risk.

To mitigate interest rate and, to a lesser extent, inflation risk, one may wish to create a bond ladder.  The idea is similar to building a CD ladder in that the investor spreads his or her initial investment over multiple bonds, each with a successively longer maturity date.  This ensures that a portion of the investment will constantly be maturing to be reinvested in a new bond with either a lower market price or a higher interest rate.

Please see the following two articles for more information on bond ladders:

Seeking Alpha: Bond Ladders vs Layering With Bond Funds

Fidelity Investments: Learn Bond Ladders

For current information on bond pricing, please click on the following link to Bloomberg.com.

For investors who are more concerned about inflation risk, a Treasury inflation indexed bond (also known by the acronym TIPS) may be appropriate.  Inflation indexed bonds offer an interest rate that is the combination of a fixed rate announced by the Treasury plus the rate of the consumer price index (a measure of price inflation).  Investors should be aware though that these types of bonds have tax consequences that are quite different from other types of bonds.  For more information on TIPS, please click on this link.  Also, potential TIPS investors should note that the fixed rate portion of the inflation bond interest rate fell to zero last May and has remained there since.  Please click on this link to The Big Picture blog for more information on the fixed rate portion of inflation bonds.

Annuities

I do not have sufficient experience with annuities to write about them in a useful manner.  However, these are fixed income products generally offered by insurance companies.  Anyone who would like more information about annuities should review the following article at The Wall Street Journal.  Also, Fidelity Investments has a helpful page on annuities at its website.

I hope my readers have found this lengthy post helpful.  Please feel free to email me at rawfinance@gmail.com if you have any questions on this subject.  Good luck with your investments!