By Kendall Little
Bankrate.com
WWR Article Summary (tl;dr) Kendall Little takes us through a number of options for the investor who wants to play it safe.
Bankrate.com
Fixed-income investments play an important role in an investment portfolio. Returns are relatively predictable, and they’re usually much less risky than stocks.
The trade-off, of course, is that in lowering risk exposure, investors are likely to see lower returns over the long run. That may be fine if your goal is to preserve capital and maintain a steady flow of interest income. But if you’re looking for growth, consider investing strategies that match your long-term goals.
Risk tolerance and time horizon play big roles in deciding how much to allocate to fixed income. Conservative investors or those near retirement may be more comfortable allocating a larger percentage of their portfolios to fixed income to minimize risk. Those with stronger stomachs and workers still accumulating a retirement nest egg probably should diversify more. Be prepared to do your homework and shop around. If you’re looking to minimize your portfolio’s risk, here are a few of the safest investments to look into.
-Certificates of deposit
Certificates of deposit, or CDs, are issued by banks and generally offer a higher interest rate than savings accounts. These federally insured time deposits have specific maturity dates that can range from several weeks to several years. Because these are “time deposits,” you cannot withdraw the money for a specified period of time without penalty. The financial institution pays you interest at regular intervals. Once the CD matures, you get your original principal back plus any accrued interest. There are several different types, including jumbo, callable and flexible CDs.
Risk: CDs are considered safe investments. However, they do carry reinvestment risk _ the risk that when interest rates fall, investors will earn less when they re-invest principal and interest in new CDs with lower rates. Or, the risk that rates will rise and investors won’t be able to take advantage because they’ve already locked their money into a CD.
Consider laddering CDs-investing money in CDs of varying terms, so that all your money isn’t tied up in one instrument for a long time. CD returns are inching up after years of historically low rates, but it’s important to note that inflation and taxes could significantly erode the purchasing power of your money.
Liquidity: CDs aren’t as liquid as savings accounts or money market accounts because you tie up your money until the CD reaches maturity, often for months or years. It’s possible to get at your money sooner, but generally you’ll pay a penalty.
-Money market accounts
A money market account is an FDIC-insured, interest-bearing deposit account. Don’t confuse money market accounts with money market funds, which are mutual funds that typically are not FDIC-insured. Money market accounts typically earn higher interest than savings accounts and require higher minimum balances. In exchange for better interest earnings, consumers usually have to accept more restrictions on withdrawals, such as limits on how often you can access your money.
Compare rates on money market accounts to find the right account for you.
Risks: Inflation is the main threat. If inflation rates exceed the interest rate earned on the account, your purchasing power could be diminished. In addition, you could lose some or all of your principal if your account is not FDIC-insured (although the vast majority are) or if you have more than the $250,000 FDIC-insured maximum in any one account.
Liquidity: Federal regulations limit withdrawals to six per month (or statement cycle), of which no more than three can be check transactions.
-Money market funds
Money market mutual funds _ also known as money market funds _ are a saving and investing option offered by banks, brokerages and mutual fund companies. Money market funds are regulated by the Securities and Exchange Commission, or SEC, and are required to invest in short-term debt securities, such as certificates of deposits and U.S. Treasury bills. Though they are not FDIC-insured, the funds have historically tried to maintain a share price of $1, but there’s no guarantee a fund will be able to maintain the share price.
Risks: The SEC prohibits the average maturity of fund investments from exceeding 90 days. Restricting investments to such short terms helps reduce risk to the investor by protecting them from major rate fluctuations that may occur over longer periods. Interest rates can vary, so there’s no guarantee of how much you’ll earn from month to month. Further, there’s no guarantee that the share price will remain stable at $1 per share. If the share price dips below $1, you could lose some of your principal. When a money market fund is unable to maintain a $1 net asset value, or NAV, it’s known as “breaking the buck.”
When investors redeem shares in money market funds, they are repaid at the fund’s NAV calculated on the day the investors place the redemption order. While money market funds are not insured, some funds are temporarily protected.
Liquidity: Money market funds, like money market accounts, often provide check-writing and money transfer privileges for shareholders.
-Treasury securities
The U.S. government issues various types of securities to raise money to pay for projects and pay its debts. Treasury bills, or T-bills, are short-term debt instruments with maturities that range from a few days to 52 weeks.
T-bills technically are not interest-bearing. They are sold at a discount from their face value, but when they mature, the government pays you full face value. For example, if you buy a $1,000 T-bill for $980, you would earn $20 on your investment.
Treasury notes, or T-notes, are issued in terms of two, three, five, seven and 10 years and pay interest every six months until they mature. The price of a note may be greater than, less than or equal to the face value of the note, depending on demand. If demand by investors is high, the notes will trade at a premium, which effectively reduces investor return. Upon maturity, investors are paid its face value.
Treasury bonds are issued with 30-year maturities and pay interest every six months. They are sold at auction throughout the year. The price and yield are determined at auction. Upon maturity, you are paid its face value.
All three types of Treasury securities are offered in increments of $100.
Risks: Treasury securities are considered virtually risk-free because they are backed by the full faith and credit of the U.S. government. You can count on getting interest and your principal back at maturity.
However, the value of securities fluctuates, depending on whether interest rates are up or down. In a rising rate environment, existing bonds lose their allure because investors can get a higher return from newly issued bonds. Therefore, if you try to sell your bond before maturity, you may experience a capital loss.
Treasuries also are subject to inflation pressures. If the interest rate of the security is not as high as inflation, investors lose purchasing power.
Because they mature quickly, T-bills may be the safest treasury security investment. The risk of holding them is not as great as with longer-term T-notes or Treasury bonds.
Liquidity: All Treasury securities are very liquid, but if you sell prior to maturity you may experience gains or losses, depending on the interest rate environment.
-Government bond funds
Government bond funds are mutual funds that invest in debt securities issued by the U.S. government and its agencies. The funds invest in debt instruments such as T-bills, T-notes, T-bonds and mortgage-backed securities issued by government-sponsored enterprises such as Fannie Mae and Freddie Mac.
These government bond funds are well-suited for the low-risk investor.
Risks: Funds that invest in government debt instruments are considered to be among the safest investments because the securities are backed by the faith and credit of the U.S. government. However, like other mutual funds, the fund itself is not government-backed and is subject to risks _ namely interest rate fluctuations and inflation. If interest rates rise, prices of existing bonds decline, and if interest rates decline, prices of existing bonds rise. Interest rate risk is greater for long-term bonds. Further, if the inflation rate rises, purchasing power can be diminished.
Liquidity: Bond fund shares are highly liquid, but their values fluctuate depending on the interest rate environment.
-Municipal bond funds
Municipal bond funds invest in a number of different municipal bonds, or munis, issued by state and local governments. Earned interest generally is free of federal income taxes and also may be exempt from state and local taxes.
According to the Financial Industry Regulatory Authority, muni bonds can be bought individually or through a mutual fund or exchange-traded fund. You can consult with a financial adviser to find the right investment type for you, but no matter which fund you choose, you may want to stick with those in your state or locality for the best income tax rates.
Risks: Individual bonds carry the risk of default, meaning the issuer becomes unable to make further income or principal payments. Cities and states don’t go bankrupt often, but it can happen. Bonds also may be callable, meaning the issuer returns principal and retires the bond before the bond’s maturity date. This results in a loss of future interest payments to the investor. Fortunately, bond funds spread out potential default and prepayment risks by owning a large number of bonds, thus cushioning the blow of negative surprises from a small part of the portfolio.
Liquidity: You can buy or sell your fund shares every business day. In addition, you usually can reinvest income dividends and make additional investments at any time.
-Short-term corporate bond funds
Corporations sometimes raise money by issuing bonds to investors. Small investors can get exposure by buying shares of short-term corporate bond funds. Short-term bonds have an average maturity of one to five years.
Risks: As is the case with other bond funds, short-term corporate bond funds are not FDIC-insured. Investment-grade short-term bond funds can reward investors with higher returns than munis or Treasuries. But along with the greater reward comes greater risk. There is always the chance that companies will have their credit rating downgraded or run into financial trouble and default on the bonds.
Liquidity: You can buy or sell your fund shares every business day. In addition, you usually can reinvest income dividends and make additional investments at any time. However, it’s possible to suffer capital losses.
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