Published May 04, 2011
Many experts see inflation and interest rates heading higher. Already, surging oil prices have helped push the annual inflation rate above 2%. And the global picture is full of turmoil -- from war in Libya to natural disasters in Japan.
In this environment, devoting some of your assets to safe fixed-income investments makes more sense than ever. There's a wide range of possibilities, depending on what you consider safe.
"Based on the uncertainty with respect to interest rates and potential inflation, we're continuing to use fixed income," says Michael Dixon, director of wealth management at Carl Domino financial advisers in Palm Beach, Fla. "But we're very cautious with the ratings of securities and durations."
The lowest-risk options, such as certificates of deposit, or CDs, and Treasury securities, offer paltry yields, while vehicles at the top of the income scale, such as high-dividend blue-chip stocks, are much riskier.
"You give up yield for safety. That's the biggest problem with fixed-income investments today," Dixon says.
Advisers agree that the basic bond strategy for a time of rising inflation and interest rates is high quality and short maturities. That's because short-term bond prices drop less than long-term bonds in an environment of rising inflation and interest rates. And high-quality bonds fall less than low-quality bonds.
Patti Houlihan, president of Houlihan Financial Resource Group in Reston, Va., recommends a "laddered" bond portfolio, which encompasses a range of different maturities. That way your bonds mature at regular intervals, so if interest rates rise, you can reinvest at higher rates. "It immunizes clients from interest rate risk," Houlihan says.
Treasuries are the highest-quality bonds, because they're backed by the federal government. But even a five-year Treasury note yields little more than inflation. "Treasuries are safe for payback, but not for investment return opportunities," says Chris Larkins, senior investment adviser at HPM Partners in Cleveland.
Corporate bonds offer higher yields than Treasuries. If you're looking for safety, you'll want to stick to investment-grade corporates. In general, the higher a company's credit rating, the lower the interest rate on its bonds -- and the lower the chances of a default.
Investors have shied away from municipal bonds in recent months, as the financial difficulties of many states and localities have led some economists -- most notably Meredith Whitney, who accurately predicted the downfall of several big banks in 2008 -- to predict massive defaults. But many advisers say those fears are overblown.
"We aren't scared off by munis," Larkins says. "Will the federal government really allow widespread defaults by state and local governments? The default rate historically is 0.2% or less. Some defaults may well occur, but sticking to high-quality issues lessens your risk."
Treasury inflation-protected securities, or TIPS, represent an option to protect yourself from inflation. They are Treasury bonds with a twist. The value of these securities and their interest payment rise with inflation and fall with deflation. The yield remains constant. When TIPS mature, you are paid the greater value of the adjusted principal or the original principal.
The problem is that 10-year TIPS yields were recently more than 2.5 percentage points below 10-year Treasuries. That means inflation would have to rise higher than 2.5% to make a TIPS bond outperform a Treasury.
"TIPS are a segment to pay attention to, but right now, we wouldn't fully recommend them," Larkins says.
One important issue for bond investors is whether to purchase individual bonds or a bond fund. The advantage of individual bonds is that if prices fall, you can simply wait for the bond to mature and generally receive the principal back.
Bond funds don't mature, so if prices fall, the only way you'll recoup your principal losses is if prices rebound. But funds offer diversity. And experts say you need at least $100,000 to $300,000 to create your own diversified bond portfolio without paying excessive commissions, unless you're just buying Treasuries directly from the government.
As for CDs, they represent a viable alternative to Treasuries, experts say. "Some two-year CDs offer a 1.49% rate, and you can re-adjust the rate once before maturity," says Ryan Leggio, an analyst for Morningstar in Chicago. That's higher than the recent 1.12% rate on three-year Treasuries.
"You can create a CD ladder and change interest rates whenever you want," even if it's only once per CD, he says. And CDs are insured by the Federal Deposit Insurance Corp., of course.
Savings accounts are an attractive FDIC-insured option, too, Leggio says. Some savings accounts have better rates than short-term Treasuries do. And if interest rates rise, Treasury prices will fall, while savings account rates will likely increase.
Given the low yield of the safest fixed-income investments, Tim Ghriskey, chief investment officer at Solaris Asset Management in Bedford Hills, N.Y., recommends considering blue-chip stocks with high dividends. Some of the country's largest utilities recently offered yields above 5%, for example.
Of course, stocks have more principal risk and volatility than the safest fixed-income investments. But blue-chip dividend stocks are among the least risky. "We think that's a great alternative," Ghriskey says.