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Fixed-income investors have special requirements and considerations. In this two-part article, Ron Redfield, CPA, PFS, addresses important fixed-income issues.
Full Article - Table of Contents
This question deals with the importance of "safety". Many people have viewed CD"s as being the best of both worlds: "risk-free" in the sense that they couldn't lose their money, yet also worthwhile because interest rates were decent. Now interest rates for even long-term CD's can barely keep up with inflation.
If people are still risk-adverse in the sense that they are not ready to invest heavily in the stock market—but they need to get a better return than conventional tools now provide—where should they put their money?
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.
Our next step is to discuss additional risks to fixed-income investors, posed by interest rates.
Ronald R. Redfield, CPA, PFS, is available for a free consultation and sample portfolio based on your investment risk tolerance levels. And you're warmly invited to request a complementary copy of Ron's text on investment philosophy.
Please contact Ron by visiting him at Redfield, Blonsky & Co., sending him an email, or calling him at 1 (908) 276-7226. Be sure and read Ron's latest commentary on financial investments, to keep up with market changes.