Facing the Challenge Posed by Paltry Yields

Here is, or ought to be, the quandary for investors who have over the last year gained an appreciation for conservative, income-producing securities:

Yes, they’re a lot safer than Internet stocks. And a guaranteed yield of some kind, such as interest on a CD or bond, or a high dividend yield on a blue-chip stock, can literally become money in the bank--a part of your nest egg whose value isn’t subject to Wall Street’s mood swings.

But after the tax man and inflation are done with it, there may not be much left of that guaranteed yield, given today’s relatively low rates. You may well wonder whether playing it safe with your money is a loser’s strategy in the long run.

It could be--if you overdo it (i.e., you invest far too conservatively for your age) or if the big surprise of the next few years is that inflation is more severe than most economists expect, leading to a surge in market interest rates that KOs older bonds.

Investors who bought long-term Treasury bonds or Treasury bond mutual funds in March, seeking safety as the stock market tumbled, already are learning that “safe� is a relative term when it comes to bonds.

If yields on new bonds are rising, as they have been for the last month, older bonds at lower fixed rates naturally lose their appeal. That means their market values decline. The result can be a negative “total return�--meaning any interest you earn on the bond is more than offset by a loss of principal value.

Since late March, the rise in long-term bond yields has made for some unhappy bond fund owners--particularly among new investors. The average mutual fund that buys long-term government bonds has suffered a negative total return of 0.4% since March 31, according to fund tracker Lipper Inc.

In the grand scheme of things, that’s hardly a disastrous loss, of course. And year-to-date most bond funds still boast positive total returns.

But the turnaround of the last month makes the point: There is risk involved in owning bonds, even though that risk may seem modest, for now, compared with what has happened with stocks over the last year.

Some income-seeking investors have a different view of rising market interest rates. They would welcome them, because current yields seem so paltry.

The decline in short-term rates this year, courtesy of the Federal Reserve’s credit-easing campaign, has pulled the average seven-day compound yield on money market mutual funds down to 4.42% from 6.09% at the start of the year.

Let’s assume that yield stabilizes around 4% by the time the Fed’s latest rate cut works its way through the financial system. Let’s further assume that 4% is what you’ll earn for all of 2001 in a money fund.

If the rise in inflation over the last two years is cresting, as the optimists say, perhaps inflation for the year comes in around 3%. Subtract that inflation rate from a 4% money fund yield and your “real� yield is a mere 1%.

But you’ll wind up with even less than that after subtracting the tax bill on the interest earned, assuming the account isn’t tax sheltered.

A 4% yield on a $10,000 money market account will generate $400 in interest for the year. If you’re in the 33% federal marginal tax bracket, Uncle Sam will take $132 of that interest, leaving you with $268, or a net yield of 2.68%.

If the inflation rate is 3%--well, you get the point. You’ve earned nothing, after taxes and inflation.

Still, all of this is relative: Even if your net interest earnings on income-generating investments are tiny or negative (after inflation), the value of your principal is likely to remain stable at best and decline modestly at worst.

So if your goal with an income-generating investment was to preserve capital--especially compared with what could happen to the money if it were invested in stocks during a bear market--you’re achieving that goal, even if your interest return is disappointing.

Looking long-term, however, bond investors have to be mindful of the damage that inflation can do to fixed-rate returns.

You can lock in an annualized yield of 5.33% today on 10-year Treasury notes. As long as inflation stays around 3%, or if it drops lower, you’ve got a decent (if not spectacular) after-inflation return of at least 2.33 percentage points, and you’re guaranteed to get the bond’s face value returned to you in 10 years.

But what if inflation soars to 6% by the middle of this decade, confounding the experts who figured that couldn’t happen? At that inflation rate your 5.33% yield will be annihilated. Moreover, you will get back your principal when the bond matures, but inflation will have drastically eroded the purchasing power of that money.

If long-term Treasury bond yields were higher today--say, 7% or so--you’d have a greater margin for error. But they aren’t, and you don’t.

Is the answer to forget about income-producing securities and just roll the dice with the stock market? Many younger people probably can make that case (other than with cash set aside for emergencies) because they’ve got the time horizon needed. Over the next 20 years, it’s a good bet that stocks will do what they almost always do in the long run: generate higher returns than bonds or money market accounts.

And equities had better generate higher returns because they are far riskier than bonds or money market accounts.

For many older investors, however, the need for some degree of capital preservation means income-oriented securities are a necessary element of a portfolio.

The question then is: How do you earn a decent return on income-producing assets while lowering the odds of being hurt if inflation surges?

Here are a few basic tips:

* Always keep some portion of your income portfolio in money market accounts, even as interest rates fall. If and when rates start to move higher again, money fund returns will quickly reflect that turnaround.

* If you’re buying individual bonds or bank CDs, “ladder� your portfolio: Split the money among bonds or CDs maturing in sequence over a period of years. That way you’ll always have some principal coming back to you, which you can invest at higher yields if market rates have risen.

Also, consider using some of your income-earmarked assets to buy inflation-protected Treasury securities within a retirement account. These securities adjust your return over time to compensate for any rise in inflation. For more information on inflation-protected Treasuries, go to https://www.publicdebt .treasury.gov.

* If you’re investing in bond mutual funds, remember that even though your principal value may decline over time if market yields rise, you’ll earn higher interest from the fund because it will be reinvesting assets at higher yields as older bonds mature.

That isn’t total protection against rising rates, but it’s at least some protection.

* If your tax bracket is high enough, think about using tax-free municipal bonds for at least part of your income portfolio. The returns may be far greater than what you’d be left with if you own taxable bonds.

*

Tom Petruno can be reached at [email protected]. For recent columns on the Web, go to http://ukobiw.net./petruno.