As interest rates on deposit accounts remain near historic lows, The New York Times recently highlighted a flourishing market that is one place to find higher yields: corporate bonds. But are these a viable alternative to CDs, savings and money market accounts?
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When interest rates are low, investors naturally start looking for higher-yielding alternatives. Certainly, most depositors stuck with savings account rates of less than 1% must have given it at least a passing thought over the past couple of years.
But looking at the nature of the corporate bond market reveals some of the risks of reaching for extra yield. Yes, corporate bonds can provide higher interest rates at a time when income is scarce, but investors who enter that market should be advised that they are stepping into a very different world from deposit accounts.
Here are four key points about reaching for a higher yield with corporate bonds.
- There is definitely an income premium to be found in corporate bonds. The Times reported that yields on investment-grade corporate bonds were recently around 3.3%. On the surface, that certainly sounds attractive compared to savings account rates at a fraction of 1%, or even Treasury bonds at around 2%.
- The reward for risk has been shrinking. Of course, the key difference between corporate bonds and either Treasuries or savings accounts is that corporate bonds are not backed by the U.S. government. That extra interest represents the reward investors are paid for taking more risk, and lately that reward has been shrinking. The spread between investment-grade corporate bonds and Treasuries has shrunk from 2.34% to 1.85% so far this year.
- Liquidity may be an issue. The New York Times also highlighted another important issue for investors: liquidity. Depending on final implementation rules related to the Dodd-Frank financial reforms, banks may be more limited in their holdings of corporate bonds in the future. Already, they have cut their holdings of those bonds in half over the past year. This dries up an important market for those bonds. When a market is less liquid, investors may have to sacrifice more price when buying or selling, which cuts into their effective yield.
- Diversification brings additional challenges. One way to diffuse the risk of owning corporate bonds is to diversify among several different issuers. However, unless an investor has hundreds of thousands of dollars to invest, the only way to get that kind of diversification would be through a mutual fund, and that raises other issues. The buying and selling patterns of a fund can impact whether investors actually earn the underlying yield of the bonds the fund owns. Also, the fee charged by the fund will reduce the yield that investors get.
With most CD, savings, and money market rates below 1%, the temptation to reach for a little extra yield is understandable. However, before taking that step, investors need to be sure that it is worth leaving the considerable safety of FDIC-insured deposits.
The original article can be found at SavingsAccounts.com:Low interest rates lead investors to consider corporate bonds
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