Fixed-Income Investors Brace for Next Fed Cut

Stock investors are hoping the Federal Reserve cuts interest rates again next week, but owners of certificates of deposit view the impending Fed meeting with a sense of dread.

And no wonder. The Fed’s four rate cuts already this year have pushed shorter-term savings yields sharply lower. Average yields on one-year CDs have plummeted, falling from 5.71% at the end of 2000 to 4.18% this week.

Economists predict the Fed will lower its target for the key federal funds rate by another half-percentage point when it meets Tuesday. The fed funds rate--the rate banks charge each other on overnight loans--is an important signal on the direction of interest rates, and lowering it will further erode returns on traditional fixed-income staples such as CDs and other bank deposits.

“There’s no question that investors are really feeling this,” says Greg McBride, financial analyst with BankRate.com, a rate tracking firm based in North Palm Beach, Fla. “Yields on deposit products have gone from five-year highs 12 months ago to the lowest yields we’ve seen since 1994. This has been a very sharp reversal in a very short period of time.”

Still, those who are willing to shop for rates or change their investment strategy somewhat can generate returns of 5% or more on their fixed-income investments, experts say. But you may have to move away from your neighborhood bank.

If you’re willing to take a bit more risk with your portfolio, the income-generating possibilities are better in corporate bonds, mortgage-backed securities and real estate investment trusts. But corporate bonds and REITs aren’t federally insured and carry the risk of default.

People who want to stick with bank accounts can still lock in a 5% rate on a one-year CD, McBride says. But probably not from your local bank.

Internet-based banks--the kind that have no bricks-and-mortar offices--are offering higher rates on CDs. But to do business with them, you must open an account online and send them checks either by wire or through the mail.

The difference in yield can be substantial, McBride adds. Several Internet banks are offering 5% or more on one-year CDs, compared with the national average rate of 4.18%. Investors who want to shop for yield can do so on the Web at https://www.bankrate.com or https://www.imoneynet.com.

Savers with long-term time horizons might consider another idea: Treasury Inflation-Protection Securities, or TIPS. The concept behind these government bonds--they’re issued in 10-year and 30-year maturities--is that their return is indexed to the rate of inflation.

The Treasury does this by guaranteeing a set yield on the principal--currently about 3.5% for 10-year notes--and then adjusting the principal value to the rate of inflation twice annually.

In other words, if you invest $10,000 in TIPS, you’ll get interest of 3.5% per year or $350. However, if inflation averages 3%, your principal investment will be adjusted to $10,300 by year-end. From that point, you’ll earn your 3.5% return on the $10,300, meaning your interest payment will rise to $360.50 the second year and will continue to rise with each inflation adjustment thereafter.

The catch: Treasury securities are free from state tax, but they’re subject to federal tax. And with TIPS, you not only pay federal income tax each year on interest received, you pay tax on the inflation adjustment of your principal--even though you won’t get the added principal until the bonds mature, says Treasury spokesman Pete Hollenbach.

A better choice for the tax-averse are inflation-indexed savings bonds, Hollenbach says. These bonds, sold in denominations ranging between $50 and $10,000, accrue interest at a rate of 3% plus the rate of inflation.

That makes the current rate 5.92% (3% interest plus 2.92% annualized inflation rate), he says. You don’t pay tax on the return until you cash in the bonds, Hollenbach adds. The downside is that you also don’t receive any interest until you cash in the bond. If you cash out in less than five years, you pay a three-month interest penalty.

Both TIPS and inflation-indexed savings bonds can be purchased directly through the Treasury, through brokers, or you can buy them through mutual funds that invest in these securities.

Investors who want to buy conventional Treasury securities can get a yield of about 4.18% now on two-year notes and 4.78% on five-year notes. Because those yields are exempt from state income tax (though not from federal tax), they may be more attractive than similar rates on bank CDs of those terms. Bank CD interest is fully taxable.

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Fed Dread

Interest rate cuts by the Federal Reserve are bad news for savers: Yields on certificates of deposit have plummeted in recent months as the Fed has slashed its key short-term rate.

Weekly average yields for 6-month and 1-year CD, nationwide

1-year CD Wednesday: 4.18%

6-month CD Wednesday: 4.02%

Source: IMoneyNet.com