Plunge in Rates Adds to Investors’ Quandary
Will interest rates continue to go down? What should I do about it?
These are questions you and many other investors may be asking in the wake of sharp interest rate declines during the past three months. The plunge has been fueled in part by expectations of lower inflation and was augmented this past week by signs that the Federal Reserve was easing credit conditions.
Even the release on Friday of the government’s producer price report, showing a higher-than-expected inflation rate of 9.4% so far this year, failed to stem the falling interest rate tide.
Many investors consequently have bet on lower rates, locking in longer-term certificates of deposit or longer-term bonds, or jumping into stocks. But not all analysts are convinced that rates can fall much further, pointing to the Fed’s continuing concern about the threat of inflation.
So should you join the crowd and bet on falling rates?
The answer depends on how much risk you can take. The investment choices are many, but here are some relatively straightforward ones, depending on your risk profile:
- “Safe and Secure” Investors.
You’re in this group if you’re an ultraconservative investor who can’t afford to lose a dime. Thus, you should stay away from long-term bonds or stocks, which could fall in value if interest rates rise. Stick with certificates of deposit, money market mutual funds or Treasury bills. All carry virtually no risk of loss of principal.
Yields on six-month CDs and money market funds nationwide are averaging 9.06% and 9.08%, respectively, down considerably from their peaks in March and April. But several still carry annualized yields of 10% or more.
According to 100 Highest Yields, a newsletter in North Palm Beach, Fla., California institutions offering six-month CDs with annual compound yields above 10% include Guardian Savings of Huntington Beach at 10.24% and Columbia Savings & Loan at 10.02%.
If you think interest rates will fall, it is still not too late to lock in a decent yield on a longer-term CD, says Robert Heady, editor of 100 Highest Yields. Institutions with the highest average annual yields on 2 1/2-year certificates are Sun State Savings in Phoenix at 11.2%, and Dominion Federal Savings in McLean, Va., and John Hanson Savings in Beltsville, Md., both at 10.59%.
As for money funds, consistently strong performers through the years include Vanguard Money Market Reserves-Prime (800-662-7447), currently paying a 10.1% annual compounded yield, and Flex-Fund Money Market Fund (800-325-3539) at 10%. The latter adjusts its management fee to keep the yield high.
Also above 10% are two funds, Dreyfus Worldwide Dollar (800-645-6561) and Fidelity Spartan (800-544-6666), that are absorbing all management fees and expenses. Complete listings of all major money fund yields can be found every Thursday in The Times.
Six-month Treasury bills now yield 8.44%. But they have the advantage of being exempt from state and local taxes.
If you’re in the top 33% federal tax bracket, consider tax-exempt money market funds. They are free of federal taxes and currently yield an average of 6.02%, according to Donoghue’s Money Fund Report. (That’s equivalent to a 8.99% taxable yield if you’re in the 33% federal bracket). Listings can be found every Wednesday in The Times.
Consistently strong funds in this group include Vanguard Municipal Bond Money Market at 6.6%, USAA Tax-Exempt Money Market Fund (800-531-8000) at 6.6% and Calvert Tax-Free Reserves Money Market (800-368-2748) at 6.8%.
Also consider money funds that invest only in tax-exempt California bonds. For California residents, they are exempt from state taxes as well as federal. Interestingly, Vanguard’s version, Vanguard California Tax-Free Money Market Fund, currently boasts a higher compounded annual yield (6.7%) than almost all tax-free money funds that are exempt only from federal tax.
- “Easy Does It” Investors.
You’re in this group if you can try for somewhat higher returns, in exchange for the modest risk of possibly losing a small portion of your capital.
One option is intermediate-term bond mutual funds. They invest in bonds of maturities usually between two and 10 years that will earn slightly higher yields than money market funds and earn modest capital gains if interest rates fall. If interest rates rise, their yields should offset any capital losses so you won’t have a net loss.
Often recommended no-load funds in this group include Dreyfus U.S. Government Intermediate, Fidelity Government Securities and Vanguard Short-Term Bond.
If you’re in a high tax bracket, consider intermediate-term tax-exempt funds. Often recommended funds in this group include Vanguard Muni Bond Intermediate and Fidelity Limited-Term Munis.
Moderate-risk investors also can buy mutual funds that invest in stocks stressing high dividends. Those payouts cushion against falling stock prices, making these funds less volatile than the market as a whole.
Often recommended no-load funds with income-oriented stocks include T. Rowe Price Equity Income (800-638-5660), Lindner Dividend (314-727-5305) and Vanguard Windsor II.
- “No Pain, No Gain” Investors.
You’re in this group if you are willing to accept high risks in exchange for high potential returns.
If you think interest rates are still heading lower, consider mutual funds investing in zero-coupon Treasury bonds. These bonds are sold at a discount, and you accrue interest by getting the full face value at maturity.
That process makes zeroes one of the most lucrative and riskiest ways to profit from falling interest rates.
One of the best ways to play zeros is through a group of no-load mutual funds managed by Benham Group (800-982-6150 in California). Each fund in the group has a different target year when zeros in the portfolio mature. The further out the maturity, the higher the potential return. Benham Target Maturities 2015 has the highest potential, Benham Target Maturities 1990 the lowest.
If long-term rates went down 1 point in a year from current levels, you could gain as much as 40% with the Benham 2015 fund, according to Donoghue’s Moneyletter of Holliston, Mass. If long-term rates sank 3 points in that year, you could more than double your money, the newsletter says. But you can lose if long-term rates rise and you must sell before maturity.
If you think stocks will keep rising, buy growth or aggressive growth stock funds. They have the potential to score the biggest gains in a bull market but the biggest losses in a bear market. Often recommended no-load funds in these groups include Janus Fund (800-525-3713), Neuberger & Berman Manhattan Fund (800-367-0770), Scudder Capital Growth (800-225-2470), Twentieth Century Ultra (800-345-2021), Nicholas Fund (414-272-6133) and Fidelity Capital Appreciation.
What if you think interest rates and inflation are headed higher? Consider gold or gold mutual funds. Gold prices have sunk for much of the past year, closing Friday at $358.10 an ounce at the Commodity Exchange, down $15.40 on a day inflation was reported to be higher.
But some analysts think the metal has dropped so far that it can’t go much lower. Some argue that the price has fallen so low that major mining firms may start curtailing production. Abundant supplies have been a major depressor of gold prices.
The riskiest and potentially most lucrative way to play gold is through gold mutual funds. They invest in gold mining company stocks, whose prices are more volatile than the metal itself. Gold funds are up only 0.51% so far this year, the second worst among fund groups tracked by Lipper Analytical Services after world income funds. History shows that gold funds are often most attractive after they’ve been performing poorly.
Often recommended no-load gold funds include Lexington Goldfund (800-526-0056), United Services Gold Shares (800-873-8637) and USAA Gold.
Of course, you may be among many investors whose risk preference doesn’t fall entirely into any of these three categories. Accordingly, build a diversified portfolio with some money in each.
Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.
