This is a question that was posed to us. It is being published in ‘It’s Up to You’, the monthly publication of The Kobrin Agency Inc.”
July 24, 2003
Ron, I walked into my bank yesterday and noticed that a 12month CD would give me 1.44%! The five-year CD wasn’t much better at 3.00%.
What is happening- are the days over when a person could get a guaranteed investment and also make some money? What are risk-adverse investors supposed to do?
What is a risk adverse investor supposed to do in this interest rate environment? As you said, typical one-year CDs are currently yielding 1.45% and five-year CDs are yielding around 3.20%. There was a time in the 70’s when CD’s and Treasury Bonds were yielding double-digit interest rates. Rates on quality bonds have fallen over the years. Holding these bonds has been a bonus for fixed-income investors over the last three years or so. Investors who held these bonds received much higher interest rates than are available today. If they looked at the value of the bond, they would see that the current value of that bond has increased substantially, assuming the term has some time left in it, from their original cost. Certificates of Deposit (CD’s) and US Treasury Bonds have been historically thought of as “guaranteed investments.” In theory, they generally are categorized as “very safe and extremely secure” investments. Keep in mind that not all fixed- income investments are known as high quality. Generally these lesser quality bonds carry greater yields, which of course are accompanied by greater risk.
Investors in fixed income have several risks attached to their investment. One of the risks is the quality of the investment and its risk of principal default. CD’s (backed by FDIC), US Treasuries and other US Government obligations have basically no principal risk. This assumes the continued solvency of the US government and the US financial system. Of course, a fixed-income investor needs to understand the use of FDIC safe harbors. Without knowledge of these safe harbors, one could have theoretical and real principal default risk in a CD. Corporate bonds are made up of high quality and low quality bonds. One must be cognizant of the risk of default in a specific bond. I often check the ratings of bonds. If you have questions on a specific bond rating you can visit this link http://www.nasdbondinfo.com/asp/bond_search.asp or call or email me, and I will try to answer your specific question.
Inflation is another risk to quality fixed income investing. Remember during the late 70’s, inflation was much higher than it is now. Hence, interest rates were higher, mortgage rates were much higher, and Money Markets were paying in the mid teens. The real return to the investor is the difference between interest rate and inflation rate. You can see in today’s environment that a guaranteed investment can yield only a slight difference between interest rate and inflation rate (interest rate less inflation rate).
Volatility of interest rates also has a definite effect on the value of fixed income. Many investors have difficulty understanding that the direction of interest rates has an inverse relationship to the current value of their fixed income investment. Here is an example. Assume that you bought a 10-year treasury a month ago and the yield was 3.20%. Hence if you invested $100,000 on June 15, 2003, the US Government has promised to give you back your $100,000 on June 15, 2013. The government will also pay you $3200 per year in interest. Now this gets interesting. Today the same 10-year bond yields 4.20%. Interestingly enough, the bond you paid $100,000 for 6 weeks ago, is probably now worth around $95,000. That is an unrealized loss of 5 % in merely six weeks. The reason for this is that you can now generate accumulated interest of $42,000 instead of $32,000 over the next 10 years; hence the value of the 3.20% bond has decreased in current value. How is that for safety? The inverse of that of course is also relevant as we witnessed an incredible bull market of quality fixed income portfolios over the last three years.
I think that an investor looking for pure safety needs to consult a competent investment advisor. An investor in safety needs to realize and understand the risks of fixed income investing. We try to dive into both the investors risk tolerance profile and also try to determine that the risk profile is also in sync with the investor’s needs. This is important in all types of investing and certainly in quality fixed income investing. We try to balance our quality fixed income investments. We often buy quality bonds outside of the US, along with heavy concentrations of US Government obligations. We try to understand interest rate environments, yet we acknowledge that we will never predict interest rate movements with any type of precision. Over the last two years we have balanced our safety minded portfolios with some theoretical inflation hedges and investments, which prospered during the weakness of the US dollar. Please keep in mind that those positions were mentioned as historical in nature, and are not necessarily our strategies in the current environment.
Please feel free to contact us for a free portfolio review. My name is Ronald R. Redfield. Our company’s name is Redfield, Blonsky & Co. Please look at our website at http://www.rbcpa.com, which has a wealth of accounting, finance, and investment information. Our phone number is 908-276-7226.