We are truly in a public storage economy when it comes to interest-rate investments.
By that I mean we are practically paying financial institutions to hold our money – to keep it safe and dry – rather than the other way around. And when you add bank fees that are assessed at every turn – late fees, check fees, phone-assistance fees – our rate of return on most bank instruments is probably negative!
On the one hand, it’s possible to find online banks that pay as much as nine times what banks and money-market funds are paying on cash accounts. But remember that nine times a few basis points still does not add up to much.
Unfortunately in this environment, investors are apt to go on a “yield safari” – a scenario where all they are concerned about is “bagging” a higher rate than they can get at the bank or on a Treasury note, with little thought to the risk of that higher income return. This may mean looking at longer maturities for bonds, or using dividend stocks as replacements for bonds. But many do not understand that there is “no free lunch” when you consider risk-adjusted returns.
My advice: make sure you are holding adequate cash reserves for your financial-planning needs (short-term requirements, emergency funds), and accept that the only real benefit you will get from these holdings is liquidity, i.e., you are storing these reserves to keep them safe and dry.
Review your liabilities. If you have high-interest-rate loans, pay them off. By avoiding those high rates, you are effectively earning that rate.
With cash reserves in place and high-rate debt eliminated, you can then accept the higher risk of fixed-income instruments such as corporate bonds, international bond funds, or a high-quality dividend fund. Investors may find some opportunities in municipals, particularly if they are affected by the new Affordable Care Act surtax on interest income for taxpayers with high-adjusted gross income.
Finally, investors should watch for one more thing. The Federal Reserve has effectively encouraged investors to take on more risk with their fixed-income securities, by announcing that they are going to hold interest rates at near-zero for the foreseeable future. This has people buying more bonds than may be prudent, because they are not worrying about rising interest rates eroding the principal value of their bonds. But that party will not last forever. At zero percent, there is nowhere else for interest rates to go but up.