Question: I have some stocks that pay dividends and some CDs and bonds that pay interest. I am worried about the fact that when interest rates go up, the value of my bonds will go down. I am looking at different sources of fixed income to help me meet my monthly living expenses. What suggestions do you have?
Answer: As you mentioned, there is an inverse relationship between interest rates and bond prices. Bond values drop when interest rates rise. Many investors are unaware of this “interest rate risk.” Today’s bond interest rates are historically low. Someday, possibly as early as this summer, rates will go up – and bond values will go down.
Investors seeking fixed income have limited choices in this low interest-rate environment. Here are some possible options:
1) Money Market Funds
Money market funds are highly regulated, open-ended mutual funds that invest in short-term fixed-income securities such as commercial paper, banker’s acceptances, repurchase agreements, government securities, certificates of deposit, and other very liquid securities. Most mutual fund families offer one or more money market funds with check writing privileges. Seven years ago, yields for money market funds were averaging close to 5.0%. Today they are yielding less than 0.1%.
2) Certificates of Deposit (CDs)
CD’s are debt instruments usually issued by banks for a fixed term. They pay interest and the longer the term, the higher the rate. 6-month CD yields are ranging between 0.12% and 1.0% and 5-year CD yields are ranging between 1.0% and 2.5%.
There are many types of bonds, which represent debt. You lend money to the government, a municipality, or a company and, in return, you receive interest payments and eventually the return of your principal. Municipal bonds are generally free from income tax. Long-term government and corporate bonds generally pay higher interest rates than short-term bonds, but they also have more interest rate risk. This week, 10-year US Treasuries are yielding just over 2%.
There are various ways to invest in mortgages. You can lend someone money directly in exchange for a deed of trust and a promissory note. You can invest in a mutual fund that invests in mortgages, such as a GNMA fund (“Ginnie Mae’s” or Government National Mortgage Association mortgages). Some real estate firms and securities firms will offer investments in a pool of mortgages. Mortgage investment yields vary considerably.
Real Estate Investment Companies manage portfolios of real estate or mortgages for investors. These companies are often publicly traded, and they can provide relatively high current income with the potential for long-term capital gains through price appreciation. Dividend yields on REITs and REIT index funds vary widely and are worth a look.
Some publicly traded companies pay dividends on their common stock, and some companies issue preferred shares of stock that pay dividends. Some mutual funds and exchange-traded funds (ETFs) invest solely in preferred stocks or dividend paying stocks. These funds offer better diversification then you would have if you were to buy shares in just a few companies. Currently, the average dividend yield for the 500 companies in the S&P 500 is just under 2.0%.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.