The Fix Is In for Fixed Income

01/23/2012 9:30 am EST

Focus: MONEY MANAGEMENT

Terry Savage

Author, The Savage Truth on Money

A lot of investment products are being advertised as completely safe, but be careful…many of these "safe" vehicles have more than a few hidden pitfalls, writes MoneyShow.com personal finance expert Terry Savage.

It’s tough to be a saver these days. The entire government seems lined up against those who did the “right thing” and saved up for a rainy day or for their retirement.

  • Today, Treasury bills yield 0.01%—that’s one one-hundredth of 1%.
  • Money market funds have waived their fees, and they are also paying nothing.
  • A six-month certificate of deposit pays less than half of 1%.
  • And a ten-year Treasury bond pays less than 1.9%.

Apparently the Fed believes that by keeping interest rates low, businesses will be more inclined to borrow money and hire people. And banks will be able to rebuild their capital as they profit on the spread between the rates they charge borrowers and the rates they pay depositors.

It isn’t working. Banks are making profits—but not loans. Businesses aren’t confident enough to borrow to expand. Jobs are being created, but only at a very slow pace.

And savers continue to suffer.

Meanwhile, inflation ate away at the value of your money by 3% this past year —and more if you spent a lot of your money on medical services, education, and energy, sectors where prices are rising at a faster rate.

By keeping interest rates low, the government is able to borrow money almost for free, while surreptitiously taking away your money by destroying its value. Inflation is running at 3%, and you’re earning 0.01%!

The Impact of Low Rates
The continued low interest rates are driving some savers to take more risk than they understand. And that could be the greatest danger of all.

Beware of jumping into products that advertise higher returns without understanding the hidden costs, concealed risks, and illiquidity. Those overlooked pitfalls are a greater danger to your wealth than dipping into your principal for living expenses.

So here’s a warning. Don’t let greed blind you to the dangers of the following investments—despite the enticing sales pitches.

Bonds
People think bonds are safe. In some ways, they are safer than stocks. If a company goes bankrupt, bondholders (lenders) are paid first, before shareholders. But there are other risks in buying bonds—risks that are not well understood.

If you buy a bond, you are lending money to a company or government, typically with a promise of receiving a fixed interest rate for a number of years. If the borrower has good credit, you can count on the fact that your money will be returned when the bond “matures” in ten or 30 years. But in the meantime, you’re stuck with that fixed rate of return.

If interest rates rise beyond the Fed’s control—because of fears of inflation, or the changing quality of the debt—then the current market value of your bond will fall! You could be “stuck” holding a ten-year government bond paying less than 2%, while rates rise.

And then if you choose to sell your bond before maturity, you could take a substantial loss. Your $1,000 low-rate bond might have a market value of only $700 if people who have cash could buy a higher-yielding, newer $1,000 bond.

That’s called interest-rate risk. And the longer the maturity of the bond, the greater the price risk!

Equity-Linked CDs
Now here’s a deal that sounds appealing. But it’s like petting a tiger and thinking it’s a pussy cat!

These hybrid products haven’t been around for a while, but now they’re coming around again in offerings from the investment department of major banks like Wells Fargo (WFC) and JPMorgan Chase (JPM). The pitch is simple: Get the safety of a bank-insured certificate of deposit combined with the upside of the stock market. How could you lose?

Turns out there are plenty of ways to lose. The principal may be 100% guaranteed—but only if you hold them to maturity. Try to get out early, and you could lose big, since there is no market for these CDs—and few will be willing to buy these packages from you if rates rise.

The FDIC guarantee holds only for the principal—not for any gains in the stock-market portion of the investment—if the bank were to fail.

Even worse, unless you buy these products in an IRA, you might be liable for taxes on the estimated return for the year—despite the fact that you don’t actually receive the gain until the CD matures.

But worst of all, you’re not getting the full return of the stock market in these products. Most don’t include dividends, which have accounted for 40% of the total market return over the years. Other products calculate the “market return” on odd formulas, including the gain from the starting date of your purchase and the Dow Jones Industrial Average performance for the entire period.

The deck is stacked against you with equity-linked CDs, almost every time. The salespeople and the institutions are the ones making the money on these “deals.” So don’t be swayed by the sales pitch.

There are literally dozens of other products, ranging from some annuities, to “structured notes,” to “capital shares” that are being touted to savers as a “safe” alternative to today’s low CD yields.

Always remember that if you’re being offered a higher return, there is always a greater risk—even if you haven’t figured it out. And that’s The Savage Truth.