With interest rates having been at or near historical lows for roughly a year now, there are two questions that I find myself answering over and over:
- Should I move some of my money out of bonds and into stocks?
- Where can I find decent interest rates?
Should I Move More into Stocks?
Many investors are wondering whether, given the low yields on bonds, it makes sense to move some of their money from bonds to stocks.
In my opinion, it does not make sense for most investors to do so. For most people, the fact that interest rates are low doesn’t do anything to increase their risk tolerance. (Quick litmus test: Are you better prepared to handle a portfolio decline of a given amount than you would be if interest rates were, say, 3% higher?)
If you were already using an asset allocation that was in keeping with your risk tolerance, and your risk tolerance has not increased, then I don’t think it makes sense to shift further toward stocks.
That said, a bond’s (or a bond fund’s) yield is the best predictor of its future returns. So, with low expected returns from the bond portion of your portfolio and no additional risk capacity to make a move further into stocks make sense, what’s an investor to do? My suggestions would be to:
- Increase your savings rate if you’re in the accumulation stage, or
- Reduce your withdrawal rate if you’re in the distribution stage.
Where Can I Find Better Rates?
For investors willing to do a little extra work, it is possible to earn better fixed income returns than what’s available via typical bond funds.
For example, it’s easy to find FDIC-insured CDs with higher yields than Treasury bonds of the same duration, despite the fact that (assuming you stay within the FDIC limits) the two have the same level of credit risk.
And as we’ve tangentially discussed in recent roundup articles, if you find a CD with a low early withdrawal penalty, it’s often advantageous to go ahead and pick a long maturity (and get the resultantly higher rate), because you will still have an easy way out in the event that a) you need the money, or b) rates rise and you want to reinvest the money at the new, higher rate.
To be clear though, this strategy isn’t something that’s only useful when rates are low. (Allan Roth, for example, has been writing about it for years.) Regardless of the interest rate environment, it’s common to be able to find FDIC-insured CDs offering higher yields than you can get from bond funds, due to the facts that:
- Institutional buyers don’t have much interest in CDs because the FDIC limit is peanuts for them, so demand for CDs is, all else equal, relatively lower than the demand for Treasury bonds (thereby necessitating higher yields to attract buyers), and
- Banks sometimes use CDs as loss leaders to draw in new customers, with the hope of earning a profit from selling them other services.