Imagine yourself at a restaurant where the entrees are a little complicated. You would want the menu to be detailed enough for you to understand the major components and preparation style of each item, and perhaps it should include some nutritional information as well.
Income investing is like that kind of restaurant. The choices are complicated, and not all the characteristics of the menu items will be to your liking. Here is what the menu of income investing choices looks like today.
Savings and money market accounts
2015 begins with savings account rates averaging just 6 basis points and money market rates averaging just 8 basis points. That may not sound very appealing, but they offer the redeeming qualities of FDIC insurance and the opportunity to shop between banks for a better deal.
The big risk with this type of account is that savings and money market rates can change at any time, so they are very vulnerable to falling interest rates. However, with rates having already fallen to nearly zero, there is not much more risk of this happening.
Certificates of deposit (CDs)
Like savings and money market accounts, CDs offer you the security of FDIC insurance, and an opportunity to shop around for better rates. The advantages that CDs have is that the longer-term ones offer higher interest rates, and by locking in a rate for a few years you can reduce your vulnerability to falling interest rates. The big danger is that locking in a rate could leave you exposed to inflation if it rises over the term of your CD.
Given today's meager rates, inflation would not have to rise very much to outpace the earning power of most of today's certificates.
T-bills and T-bonds are both debt securities backed by the U.S. government, with T-bills being short-term in nature (one year or less) while bonds are longer in duration. T-Bills are stable and can be a way to get government backing on more than the FDIC insurance limit without the inconvenience of spreading your money around to different banks.
The downside is that T-Bill rates are today about as low as savings and money market rates, with no opportunity to shop around for a better deal.
Bonds offer higher yields than T-bills or deposit accounts, but are subject to price fluctuations. A Treasury bond's value is guaranteed by the government at maturity, but in the meantime its price can vary greatly. Bonds are especially vulnerable to losing value in periods of rising inflation.
Corporate bonds typically pay more interest than their Treasury counterparts, but in addition to the potential price swings and vulnerability to inflation, corporate bonds carry the risk of default if the issuing corporation runs into financial trouble.
Again, these offer the opportunity to earn more than Treasury yields, but in addition to the same types of risks as corporate bonds, you have to add in currency risk. That can be damaging at times like last year, when the value of the U.S. dollar rose relative to foreign currencies.
The truth is, if this were a restaurant menu, you might choose to eat somewhere else. Income investing is not very appetizing these days. The low-interest-rate environment puts the onus on saving more and possibly working longer. Those solutions are no longer short-term fixes to a temporary emergency -- they have become essential realities of retirement planning.
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