Fixed Income Investing In Today's Low Rate Environment
The low interest rate environment we have experienced for several years appears to be continuing into 2021 with no significant sign of upward momentum for now. Federal Reserve Board Chair Jerome Powell recently stated that the central bank’s intention is to maintain ultra-low interest rates until the economy recovers further. For many, the fixed income portion of their portfolio is an important asset class for generating needed income, helping to preserve their hard-earned capital, and for diversifying risk away from equities.
This extreme low interest rate environment continues to present challenges for investors seeking yield on their fixed income investments, especially those in or nearing retirement. How do various fixed income instruments stack up in terms of return and risk? There are some fixed-income investments that pay higher yields, but they come with additional risk. Below is a list of some income-generating investments to consider when looking for yield:
- Online Savings Accounts – Traditional savings accounts at most banks are not paying much, if any, interest right now. But some online banks are offering a bit higher rates on their FDIC insured savings accounts – some as high as .6%. With inflation running at about 1.68% right now, the risk with all savings accounts is that you’re not even earning enough to keep pace with inflation (“purchasing power” risk.)
- Bank Certificates of Deposit – If you’re willing to lock up your cash for some period of time, you may be able to get slightly higher interest with a CD. A 2-year CD is paying as high as .7% right now at some banks. But a CD carries several additional risks in addition to purchasing power risk. CDs also have interest rate risk (interest rates may go up but you’re locked in at the rate you bought) and liquidity risk (CDs are not liquid prior to their maturity date without incurring a penalty.)
- U.S. Government Bonds (Treasuries) – Considered one of the safest investment because they are backed by the full faith and credit of the U.S. Government, some Treasuries can provide slightly higher yields than cash instruments without taking on much additional risk. Currently, you can expect a yield of about .8% for a 5-year Treasury up to about 1.6% for a 10-year Treasury. The additional risk here is market risk if you decide to sell your bond prior to maturity. Your bond may be worth less in the secondary market if interest rates have risen since you purchased your bond.
- Municipal Bonds – Bonds sold by municipalities are often attractive to investors in higher tax brackets because the income from a municipal bond is generally tax exempt at the federal level and may also be tax-free at the state level. Depending on how long you are willing to hold the bond, you could receive anywhere from 1-2% of tax-free income from a highly-rated municipal bond (equivalent to 1.7% - 3.3% taxable yield assuming a 40% effective tax rate.) The additional risk with these bonds is the credit worthiness of the underlying municipality (default risk).
- Corporate Bonds - If you are looking to purchase bonds that offer higher yields, one option is investment-grade corporate bonds. These bonds are issued by companies with solid balance sheets and cash flow. The current average yield on an investment grade corporate bond is just over 3% currently, with the historical average closer to 6.5%. While the risk of default is higher than with Treasuries or Municipals, investment-grade bonds are still considered reasonably safe from default.
- High-Yield Bonds - A High-Yield Bond is a debt instrument that is considered below investment-grade. Since it carries more default risk than a higher quality bond, it also will pay you a higher yield, or premium, for being willing to take that risk. Currently, the high-yield bond average yield is about 3.6% with the historical average closer to 6.85%. As with all investments, you must weigh the risk in relation to the reward – are you being rewarded significantly for taking on additional risk and what level of risk can you afford to take?
- Alternatives to traditional fixed income – with interest rates so low, many investors have had to think outside the box when looking for yield to meet their income needs. Many Real Estate Investment Trusts provide a monthly dividend from rents and lease payments that are not directly tied to interest rates. There are also “Structured” products or market-linked products that can provide higher yields based on the growth in the equity markets, but also provide a floor to limit downside risk. These types of investments expose you to additional risks so it is important to work with your financial advisor to build an appropriate portfolio with your specific goals and risk tolerance in mind.