Rising Interest Rates Mean Opportunity for Investors and Savers
By Bill Addiss
Since the financial crisis of 2008, short term interest rates in the US have been declining or historically low. Now, for the first time in over a decade interest rates are rising. Additionally, with unprecedented transparency, our Federal Reserve tells us they expect short term rates to rise even further. This presents an opportunity for both investors and savers alike.
The short-term investments highlighted below are called money market instruments, meaning they are very short term in nature (usually less than one year), offer safety and liquidity. After years of being out of favor due to the low interest rates they offered, these investment vehicles are once again gaining in popularity. This article explains what money market vehicles the investor/savers might use to enjoy the higher income now available for their savings and cash management needs.
Certificates of Deposit (CDs)
This is a savings certificate usually issued by a commercial or savings bank. It is a way for a bank to borrow money. The bank offers the investor/saver a fixed rate of interest for a specific period for the use of their money. These investments are considered very safe, as they are insured by a government agency (FDIC) for up to $250,000 per institution/per depositor. Most banks offer CDs with a variety of different maturities that usually range from one month to several years. Although the traditional minimum investment in a CD is $1000, many banks now offer them in even smaller denominations.
If you are seeking to invest in a CD, it is highly recommended that you check what rates are offered at a variety of banks, not just one or two, as the rates offered by different banks can vary greatly. It certainly pays to shop around! Given the recent rise in short term rates, banks are now offering higher rates on their CDs than they have in years. Be wary, however. Should the investor/saver want to redeem, or cash out of their CD prior to its maturity, the issuing bank will charge a substantial interest penalty which varies from bank to bank. Accordingly, it is suggested that you purchase a CD for the maturity that best meets your individual needs. Credit Unions also issue CDs, and these are also deemed very safe as they are insured by the National Credit Union Insurance Fund (NCUSIF), which is like the FDIC.
Money Market Funds
These are mutual funds which are designed to offer the investor/saver a safe, liquid investment. These funds are valuable for investors/savers because they are very liquid and they almost never fluctuate in price, while still offering their investors income. Most money market funds offer same day liquidity, meaning you have immediate access to your money, it is not locked in for any specific period. Additionally, as they rarely fluctuate in price, the investor expects to get a dollar back for every dollar they invest, while earning interest on the investment.
Given the recent rise in interest rates, most money market funds are now yielding over 2%, illustrated in the below chart. Many money market funds even offer a checking account option, allowing you to use these mutual funds like a checking account, writing checks against your money market fund balance. However, it is VERY important to note that although the portfolio managers invest in safe, short term investments like Treasury Bills and CDs, the fund itself is not insured like a checking or savings account would be.
Finally, many mutual fund companies offer money market funds which invest in short term municipal bonds. This gives the investor all the opportunities highlighted, as well as the additional benefit of tax-free income. Based on your individual tax considerations, this can be a very worthwhile benefit.
Treasury Bills (T’Bills)
These are certainly the safest of the short-term investment opportunities. A T’Bill is a short-term investment vehicle issued by the United States. It carries the full faith and credit of the US Government. T’Bills are issued with maturities of 1, 3, or 12 months and they are issued in maturity values of $1000. Because they are the safest of investment vehicles that also means they are among the lowest yielding, but these yields are also on the rise. Currently, T’Bills offer yields more than 2.25%. Unlike CDs, they can be sold prior to maturity without any interest rate penalty, but that could result in a loss of principal. Therefore, as when investing in CDs it is recommended that the investor/saver invest in the T’Bill maturity that best fits their needs.
T’Bills can be bought thru a bank or broker, but the US Treasury also offers them directly thru a program called Treasury Direct. There are many benefits of buying T’Bills directly thru the Treasury Direct program, not least of which is that they can be purchased without ANY commissions or fees and can be purchased in denominations as small as $100 each. Visit Treasury Direct for a further explanation of the benefits of T’Bills, as well as instructions on how to buy them.
Bonds offer protection that stock investors don’t have. They are issued by the Federal, state or regional governments and corporations when they need to borrow money. Unlike stocks, which offer opportunities for upside growth, bonds are traditionally bought for safety and income. That’s because bonds have a maturity, a date when the money is paid back to investors. In the U.S., investors can choose a maturity that best meets their needs, from less than a year up to 30 years. It’s possible to sell a bond prior to its maturity, but only at prevailing prices, which could result in a loss of principal. The issuer also pays bondholders an annual interest rate, referred to as the coupon, over the life of the bond. Bonds are always issued in denominations of $1,000, referred to as the par, notional or principal value.
The primary risk to a bond investor is taking on credit risk. By buying the bond and lending the issuer money, the investor is taking the risk by assuming that the issuer will pay them back when the bond matures. The less credit worthy the issuer of the bond is, the more risk the investor takes. Accordingly, a less credit-worthy issuer will offer investors a higher coupon to accept the risk. Conversely, the lower the credit risk, the less the issuer would have to pay in interest to compensate the investor. U.S. treasury bonds are considered the safest bonds in the marketplace; the interest rate they offer is usually referred to as the risk-free rate. Bonds with the lowest quality are called junk or high-yield bonds. They offer the highest rates of interest--along with the highest risk of repayment at maturity. There are rating agencies that help the investor analyze risk by ranking the bonds. Here are the scales used by the two most popular agencies, Moody’s and Standard & Poor.
Given the recent rise in short term rates, the money market arena is once again offering interest rates that warrant attention. After more than a decade of low, unattractive rates, these products are once again attractive for investors/savers and the prospect of further increases in interest rates will likely continue to make them even more attractive.
If you are concerned about stock prices trending lower, worried that we might be entering a bear market or if the increasing volatility we are experiencing is causing you concern, then there are proactive steps you can take. To do nothing is in fact doing something: it’s keeping you exposed and unprotected, vulnerable to the very risks that are concerning you. Consider the suggestions included above as a way of more effectively managing your assets.
About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.