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Fixed-income investing beyond the bank

Interest rates are down and may go down more. That’s not so hot if you want to buy bonds or put money in the bank. So where’s the best place to put your fixed-income holdings?
/ Source: contributor

Interest rates are down and may go down more. That’s great if you want to borrow money, but it’s not so hot if you want to buy bonds or put money in the bank.

So where's the best place to put your fixed-income holdings?

It depends, of course, on your time horizon, tax situation and stomach for risk. Generally, though, under today’s conditions it doesn’t pay very well to tie your money up for the long term.

And it may pay to look beyond the ordinary holdings like bank savings and money market funds. Top-rated five-year municipal bonds, for example, pay the equivalent of nearly 4.7 percent for investors in the 28-percent tax bracket. At the same time, a five-year Treasury note yields just 3.4 percent.

To stimulate a growing economy, the Federal Reserve has cut short-term interest rates — the Fed funds rate — to 4.25 percent, down from 5.25 percent just a few months ago. While there is lots of speculation about whether the Fed will hold rates steady or cut further, not many analysts expect it to raise rates, which it does to head off inflation.

Long-term rates are not set by the Fed but by supply and demand as traders buy and sell bonds among themselves. Investors worried about high risks in the stock market and the ripple effects of the subprime mortgage crisis are eagerly buying up safe securities like U.S. Treasuries. That demand drives bond prices up, and that forces yields down.

If that’s confusing, imagine a $1,000 bond that paid its owner $50 a year, or 5 percent. If demand drove that bond’s price to $1,250, the $50 payment would be just 4 percent of the bond’s value. (It works the other way, too. If prevailing interest rates rise, prices of older bonds fall, since no one will pay full price for a bond with a below-market yield.)

The bond’s owner would be pretty happy about a price gain. But it takes an expert to make money speculating on changes in bond prices. Most ordinary investors focus on the yield – the steady interest earnings.

And for them, the picture is not pretty. Yield on the 10-year U.S. Treasury note, a benchmark for long-term rates, has fallen to about 4 percent, compared to 5.25 percent last summer.

While international traders with billions to invest may have no choice but to buy Treasuries, small investors have other options.

Certificates of deposit
The average 12-month certificate of deposit sold at a bank pays 4.4 percent, according to And your principal would be insured by the federal government, making it just as safe as a savings account. Invest in a Treasury instead and you would earn less and risk losing principal if interest rates were to go up.

Usually, you get a higher yield if you agree to tie your money up longer. But these are unusual times: Yields are virtually the same for five-year CDs as for one-year ones.

The only reason to tie your money up for five years or longer would be to lock in today’s rates in case yields fall further. No one knows for sure what will happen, but yields are already pretty low by historical standards.

Municipal bonds
As I said, it may pay to look further afield. Municipal bonds are sold by state and local governments to raise money for public projects, like roads or government buildings. Interest earnings on munis are exempt from federal tax, and are generally free of state and local tax in the state that issued the bond.

The tax exemption means you have to do a little math to make an apples-to-apples comparison between a muni and a taxable investment such as a bank CD or Treasury.

Subtract your federal income tax rate from 1 and divide the result into the muni yield. For example, a person in the 28 percent bracket would divide .72 into the 3.35 percent paid by the average AAA-rated two-year muni, to get a “taxable equivalent” yield of  4.65 percent.

In other words, you’d make the same on the muni as you would after paying taxes on earnings from a Treasury or CD paying 4.65 percent. Since two-year Treasuries are paying only about 3 percent, you’d do better with the muni. But if you’re in a low tax bracket, a CD might be better, since the tax exemption on the muni wouldn’t be very valuable to you.

Most people who buy individual munis use full-service brokers. To avoid that hassle and expense, consider a mutual fund holding municipal bonds. Shop for them — or any other funds discussed in this column — at If you live in a state with high state taxes, like New York, look for a fund specializing in your state’s munis, so save on state taxes on interest earnings.

Keep this in mind, though: The value of your fund shares is affected by the changing values of the municipal bonds it owns, so your interest earnings could be offset by falling bond prices if prevailing interest rates rise. The only way to guarantee a given yield is to buy an individual bond and hold it until it matures. At that point the issuer will pay you the face value of the bond.

Bond funds
For long-term investors, mutual funds specializing in bonds are a good way to go. They offer professional management and diversification. And you don’t have to tie your money up – you can sell your fund shares any time you want.

However, you cannot predict your interest earnings for sure, since they depend on an ever-changing mix of bonds in the fund. Also, your return will be a combination of interest received and profits — or losses — on the bonds in the fund. It is possible to lose money in a bond fund, just as it is in a stock fund.

There are too many types of bond funds to discuss in detail. Generally, keep in mind that funds containing bonds with short times to maturity — a few months to a few years — are safer than funds with long-term holdings — 10 to 30 years to maturity, for instance. But the long-term funds usually provide higher returns.

Also, some funds have very safe bonds, such as Treasuries, while others have riskier ones, such as high-yield corporate bonds — also known as “junk” bonds. Riskier bonds usually have higher yields but more chance of default — which is when the bond issuer fails to make the interest payments, or to pay back the principal at maturity.

In shopping for bond funds, pay special attention to expense ratios and other fees. If the bonds in the fund earn only three or four percent, you don’t want to pay half of that in fees. Some of the cheapest funds charge 0.3 percent or less.

Money markets
Top money-market accounts and funds are paying upwards of 4 percent, and in a few cases 5 percent — or even a tad more. This makes them pretty appealing.

With a money market account at a bank or brokerage, or a money market fund with a mutual fund company, your principal is very safe, though it’s not government-guaranteed as in savings accounts or CDs. And you don’t have to tie your money up. You can draw money out at anytime with a check or debit card.

On the other hand, you don’t lock in a yield as you do with a CD. Yield will fluctuate constantly, so you cannot predict your income.

A money market is a good place to stash a rainy day fund or cash you’ll need over the next few months. It’s probably not the best place for a long-term fixed-income investment – for retirement, for example.

Shop for money market accounts at, or for funds at the Morningstar site.

Savings bonds
Another popular source of interest earnings is U.S. Savings Bonds. Unfortunately, a regulation taking effect Jan. 1 limits the annual purchase of savings bonds to $5,000 per person, down from $30,000. (The limit’s $10,000 if you buy half electronically, half in paper form.)

Also, note that although they pay interest for 30 years, savings bonds are no good for people who need steady income, as you don’t receive the interest payments until the bond is redeemed. You cannot redeem a savings bond until you’ve had it for 12 months, and if you do so in the first five years you give up the final three months’ interest earnings.

New inflation-indexed bonds sold through April 30 will pay an annual rate of 4.28 percent, but only for the first six months from your purchase date. After that, the rate will be adjusted every six months by adding 1.2 percentage points to the annual inflation rate. That means the so-called I-bond will always keep ahead of inflation, but not by much. Your principal is guaranteed against loss, just like a bank savings account.

The government also sells EE bonds, but they’re paying only 3 percent.

Savings bonds can be bought at many banks, or directly from the government. For more information, go to the Treasury Department Web site.

Treasury Inflation-Protected Securities are another form of U.S. government bond designed to protect investors from inflation. Different TIPS mature in 5, 10 or 20 years. Currently, five-year TIPS pay about 1.3 percent above the inflation rate. So if inflation ran at the long-term average of 3 percent, you’d earn 4.3 percent.

Unlike savings bonds, TIPS do provide steady income, and they protect your principal if you hold them to maturity. Their inflation adjustments are done by adding to principal to offset inflation. As the principal rises, so do the interest earnings.

Unfortunately, the routine contributions to principal are taxable in the year they are made, even though you don’t actually get the money until the bond matures.

TIPS aren’t particularly generous right now, and they are complicated, but Treasury does have information online where you can learn more about them. They are worth a look, though, if your top priority is to protect yourself from inflation. You can buy them through the Treasury Web site mentioned above, or through mutual funds.