If you hate investment risk, high interest rates are great. With a Catch.
“All investments involve risks.” That’s a standard Securities and Exchange Commission warning.
Be careful. But keep in mind that unless you take some risk, you won’t get much return. This trade-off between risk and return is an essential part of investing, even if you have a low risk threshold.
Maybe you can’t afford to lose money, you don’t have enough time to recover from a temporary loss, or you just can’t stand the idea of risking your money.
If this sounds like you, there’s good news. Interest rates are much higher than they were a few years ago, although they have fallen somewhat recently. For risk-averse investors, the terms of the classic trade-off have changed in your favor. Without taking on more short-term risk, you can get better returns.
However, fixed-income investments are not a panacea. Over the long term, they have produced lower returns than the stock market as a whole, and will likely continue to do so in the future. Paradoxically, if you overemphasize safety by over-investing in fixed income, you may be giving up some degree of prosperity later. Balancing these issues is what the risk-return tradeoff is all about.
When rates were low
Lower interest rates generally stimulate the economy. They’re better for borrowers – including people looking to get a mortgage, pay off a credit card or finance a business. Lower interest rates also benefit risk-taking investors because the stock market typically thrives when money is cheap.
But higher interest rates are better for people who save money, including risk-averse investors who have managed to build up a nest egg and want to turn it into a safe, rich stream for retirement. To their chagrin, interest rates – also called yields – started falling in 2007, in the early days of the financial crisis. This meant that if you bought a newly issued security and held it until maturity, you would have received little income for it. Only this year, and thanks to the Federal Reserve’s long battle against inflation, have long-term interest rates returned to pre-financial crisis levels.
The implications of changing returns could be dire for anyone hoping to live off the income stream generated by bonds or annuities.
Consider this. A retiree who has a 10-year treasury note in January 2000 captured a 6.68 percent return, earning $6,680 annually over the next ten years on a $100,000 investment. But in January 2009, deep into the financial crisis, the yield on a newly purchased 10-year Treasury bond was just 2.87 percent, yielding just $2,870 annually for an investment of the same size.
The implications of these low returns for risk-averse investors were not initially widely reported, probably because for bond traders – who are looking for profits, not years of guaranteed income – the falling yields are a Good thing.
Keep in mind that, as part of the bond calculation, yields and prices move in opposite directions. When market yields fell, people who already owned bonds went and sold thim benefited from higher prices. Falling returns also generally helped those who owned bond funds and exchange-traded funds. The return of bond funds is determined both by the yields – which fell – and by the prices that rose. For longer-term securities held by funds, price gains have generally exceeded losses.
The painful part
But for risk-averse investors looking for stable long-term returns, problems arise precisely when returns are low. That started happening more than a decade ago. In a 2013 column, I pointed out that a risk-averse, recently retired couple with a million-dollar savings fund invested in fixed income at the time could easily deplete their assets within a decade because their income stream would be quite low. They would probably improve their prospects, I suggested, if they moved some investments into the stock market.
And indeed, the market returns of the past ten years show that the assessment was on the right track. The S&P 500, a benchmark for the US stock market, returned almost 12 percent annually, while the investment-grade bond market returned just 1.5 percent.
But investing in shares involves risks. Retirees should have sufficient resources – both financial and emotional – to weather a heartbreaking decline.
There was another safe option. The couple could also have increased their retirement income quite safely in 2013 by purchasing a cheap, simple annuity – a single-premium immediate annuity (often referred to by the acronym SPIA) – to supplement their retirement savings and Social Security benefits. In 2013, a $100,000 investment in such an annuity by a 65-year-old would have yielded an average annual lifetime payout of $6,348 for a man and $5,904 for a woman. archive from the website instantannuities.com shows.
Both income streams were much higher than the couple would have received from 10-year Treasury bonds when the 2013 column was written, but lower than what the stock market yielded.
Higher rates
Today the situation is more favorable for risk avoiders.
A newly purchased 10-year Treasury bond will produce approximately $4,250 in annual income on a $100,000 investment – compared to just $640 on a new Treasury bill purchased in April 2020.
The income from single premium immediate annuities is also much better. In April 2020When interest rates were low, the annual payout on a $100,000 investment for a 65-year-old was $5,676 for a man and $5,352 for a woman. In Novemberpayouts had risen to $7,380 for a 65-year-old man and $7,068 for a woman.
In practice, bonds offer much more flexibility than annuities, either by purchasing a series of individual bonds with maturities tailored to your needs or by holding an investment-grade bond fund. Kathy Joneschief fixed income strategist at the Schwab Center for Financial Research.
“Higher interest rates are obviously better for people who want the income that bonds provide,” she said.
Total refund
But investing solely in fixed income is not ideal, even for retirees, with the exception of those with an expected lifespan of only a few years left and limited resources. For starters, even if interest rates are high, inflation will eat away at least some of the income.
“You have to be careful not to succumb to the ‘money illusion,'” he said Joel Dickson, global head of consulting methodology at Vanguard. “You may think you’re doing well,” he said, but your purchasing power will decline as prices rise.
The stock market tends to outperform inflation for long periods, and Mr Dickson and Ms Jones both said a “total return” approach probably made sense for most people, even retirees. This means that in addition to bonds, you should also maintain a well-diversified portfolio of stocks.
Keep in mind that there are tradeoffs when investing. There is no one perfect answer for everyone. Yes, higher rates are a boon if you want to capture revenue. But the total returns of investments that include equities are likely to outperform pure fixed income investments, if you have the time and courage to ride out big market downturns.