Low Interest Rates

Investing in a Low Interest Rate Environment

Low interest rates create a dilemma. Do you accept a low return because you feel you must protect your principal? Or do you take on greater investment risk in order to try for a higher return? In balancing those two concerns, here are some factors to think about.

Consider laddering your CDs

When yields on Treasury bonds began dropping last year, many investors were attracted to certificates of deposit (CDs) offered by banks that needed to attract capital. However, interest rates won't stay low forever, and at some point you may want access to your money before a CD matures. One way to achieve higher rates while retaining flexibility to adjust your strategy over time is to ladder CDs. Laddering involves investing in CDs with varying maturity dates. As the shorter-term CDs mature, you can reinvest in one with a longer term and higher rate. Over time, laddering can give you both the higher rates typically offered by longer-term CDs and the ability to adjust as interest rates change.

Example: Susan wants to invest $60,000 in CDs. She puts $20,000 in a six-month CD that pays 2.6%, another $20,000 in a three-year CD that pays 3%, and the final $20,000 in a five-year CD that pays 3.5%. When the six-month CD matures, she reinvests that money in another five-year CD. When her two-year CD matures, she reinvests it in still another five-year CD. At that point, funds from a maturing CD will be available roughly every other year, but will earn the higher five-year rate. If rates are lower when a CD matures, she has the option of investing elsewhere. (This is a hypothetical example and doesn't represent the results of any specific investment.)

Pay attention to expenses

Low returns magnify the impact of high investing expenses. Let's say a mutual fund has an expense ratio of 1.00, meaning that 1% of its net asset value each year is used to pay operating expenses such as management and marketing fees. That 1% represents a bigger relative bite out of your return when the fund is earning 3% than it does if it's earning 10%. At the higher number, you're losing only about 10% of your return; at 3%, almost a third of your return goes to expenses. Before investing in a mutual fund, carefully consider its fees and expenses as well as its investment objective and risks, which can be found in the prospectus available from the fund. Read the prospectus carefully before investing. If you prefer individual stocks, keep an eye on trading costs.

Think about your real return

Low interest rates may not be quite as problematic as they seem. Even if you're earning a low interest rate, your real return might not suffer too much if inflation is also low. Real return represents what your money earns once the impact of inflation is taken into account. With an annual inflation rate of 0.1%--the December 2008 Consumer Price Index (CPI) figure--a bond that pays 3% would produce the same real return as a bond that pays 5% when annual inflation is running at 2.1%.

Compare interest rate and yield spreads

When market instability drove many investors to the safety of Treasury bonds, their prices rose and yields fell. As a result, the spreads between Treasury yields and those of corporates and municipals have been relatively high over the last year because non-Treasury bonds have to offer higher yields to compensate for investors' anxiety about the safety of their principal and possibility of default.

Consider small changes

You may not need to remake your portfolio completely to seek a higher return. For example, if you're in Treasuries, you could move part of that money to municipal bonds, which may involve greater risk of default but whose net returns are boosted by their exemption from federal income tax. Or you could shift a portion of your stock allocation to dividend-oriented stocks and ETFs, or preferred stock.

Look for buying or selling opportunities

Interest rates also can be used to help evaluate equities. Some analysts like to determine the relative value of the stock market using the so-called Fed market valuation model. (Though not officially endorsed by the Federal Reserve Board, the method evolved based on a 1997 Fed report.) The model compares the earnings yield on the S&P 500 to the 10-year Treasury bond's yield. If the S&P's yield is higher than the T-bond's, the model considers the market undervalued relative to bonds. If the Treasury yield is higher, the market is overvalued. However, this is only one of many valuation models and shouldn't be the sole factor in your decision.