This seems to be a popular topic with our readers. I often get e-mails asking the question: “How can I earn more income from my investment?” It doesn’t take a rocket scientist to realize we’ve been living in a low interest rate environment for over five years now.
So “risk free” returns from either bank CDs or the US Treasury, for the most part, are a losing bet.
This is because the Federal Funds rate has been at 0% – 0.25% for the last five years with perhaps many more years to come, and quantitative easing. These measures by the FED pushes down all fixed income investments rates: from bank CDs to high-yield bonds.
I’ll go through all of the possible investment options that earn income, and list the pros and cons for each. For some of the options, you’ll find helpful links to more detailed articles.
Checking out Ratebrain’s web site I see the highest CD is from Connexus Credit Unit at 2.00% APY for a five year CD. Second up is Discover Bank’s 10 year CD at 1.95%.
I don’t know about you, but nether sounds like a great deal. The Federal Reserve has gone on record stating they are targeting a 2% inflation rate. Historically, the FED tends to overshoot their targeted rate, so not including taxes, you are losing money in real terms.
Though this isn’t to say you shouldn’t have some money invested in CDs — you should definitely have some savings in Bank CDs — they are not subject to a rising interest rate, unlike bonds and bond funds. To put it another way we are at very low interest rates for fixed income.
Logically we only have one way to go from here…UP! While it’s possible for rates to go lower, rates cannot go below zero. So there’s much more risk in rates going higher. When this happens returns for bonds will go lower and even possible negative.
Checking and Savings Accounts
Another option are high interest checking and savings accounts. Again using Ratebrain, I found the highest checking account available is at 3.00% APY.
While this is better deal than Bank CDs, they are subject to rate risk. Meaning the rate is not fixed and could be changed at anytime. So while you are getting some return on your money, it’s possible the bank will change.
On the positive side your money will be very liquid, and can withdraw at a moments notice. It appears the highest savings accounts are 1.00% APY and under. So unless you are using them for short-term savings (under one year), you might want to put your money elsewhere.
US Savings Bonds
Investing in I Bonds is something I’ve mentioned previously. Though, like everything else on the list, it isn’t as good of a deal as it’s been previously.
The current US I Bond earns 1.18% APY and while this return is not great, it is tied to the rate of inflation — so if inflation rises, so will your I Bonds. The other advantage with I Bonds is they are tax-deferred until you redeem them and they are not subject to interest rate risk as well.
Unlike TIPs they never can yield a negative return and they make a decent choice for mid-term (3-5 years) savings. EE Bonds are not so much a good deal, and are currently returning a 0.20% through October 31st, 2013.
Currently TIPs have a real negative return. In otherwords, not even including taxes, you are paying the government to hold on to your money. It’s not exactly a good bet.
Other US Treasuries are a bad deal as well. The 10 year treasury currently yields 1.94% and shorter maturities are even worse. So while they have the guarantee of the government, they aren’t earning much compared to the inflation rate.
There are many boring stocks which have increased their dividends annually. They are called dividend aristocrats, and have a list of current stocks on our site.
The nice thing about dividend aristocrats is every year your dividend payout is slightly more. So the longer you hold onto the stock the more your annual dividend. However, the disadvantages of any dividend stock are:
- Dividend payout can end at anytime. During the 2008 crisis a few long-term dividend payers stopped paying a dividend
- While the dividend payout is nice the principal invested may lose value.
Like many of the other fixed-income investments listed here, it’s also a crowded trade — meaning many investors are also looking for yield, and are turning to dividend paying stocks as well. As stock prices increase, this pushes down the effective yield. So the higher the prices of the stock rises, the more likely the lower the yield.
The other disadvantage is, stocks are NOT the same as bonds. Stocks typically vary more in price than bonds. So while you are generating annual income, it’s possible your principal loses value. Though at the current rates for bonds, it is also possible for individual bonds to lose principal, if sold before maturity.
High-yield bonds (otherwise known as junk bonds) are a higher risk to default compared to better rated corporate bonds. While the economy has improved since the 2008-2009 recession, they were a better investment.
At the current state of the economy they have been yielding less, but with the same risk. Investing in high-yield bond funds can be dangerous, if the rates rise quickly. With any bond investing, understand the difference between owning a bond and a bond fund.
Muni bonds really only makes sense when you are one of those “evil” one percenters who are in the upper-income brackets. Your effective yield is much higher than the real yield after taxes.
With muni bonds you can earn more tax-free money, than in other taxable investments. Highly rated muni bonds can be a good investment, but like other investments can get hit if interest rates rise.
Ginnie Mae Bonds
Ginnie Mae bonds are a possible investment option for getting a higher yield. Since most individuals do not have enough savings to properly invest directly in Ginnie Maes, this means most individuals will own a Ginnie Mae bond fund. If interest rates rise they could suffer a dramatic fall.
Lending Club and Prosper
With both services you have the ability to earn 10%+ APY on your investments. Though, this is only possible with considerable risk and active management needed.
The downside of either service is your investment isn’t very liquid. Once you invest in a note, it will take some time to unwind your investment. Either you need to wait 3-5 years for your note to be fully paid, or try selling on the secondary market.
So while the returns are good, and from my experience returns are very stable, the money invested is pretty much locked in for a long period of time.
Real Estate Investment Trusts, or REITs for short, are another possible option for getting a higher yield on your investments. Individually they invest in either real estate or real estate mortgages and are a great way to diversify into real estate, without directly owning property.
There are many types of REITs available: from malls, to self storage units. Income generated from REITs are typically stable, since 90% or more of the income produced must be distributed. However, since they are taxed as ordinary income in your portfolio, the disadvantage to REITs are they are not so great for taxable accounts.
Master Limited Partnerships, or MLP for short, typically own natural gas and oil pipelines. By name, they are partnerships that have the tax advantages to be placed in a taxable account, with historically stable returns.
At the moment, returns for the average MLP are 5%; down from the historical 8% and they have a low correlation to bonds and stocks. The disadvantage is that you need to own one for long period and can be complex to deal with tax issues.
Getting a Higher Yield
To generate higher yields in the current economic environment, you need to own a mixture of the various assets listed above. The only chance you’ll have to keep up with inflation is by asset allocating your savings in various “risk-free” and risky fixed-income assets.
It’s even possible you’ll even have a positive return in real terms. This is unfortunately the cause of the times we currently live in — long gone are the days of just putting your money in bank CDs and earning 4-5% APY.
Image courtesy of Stuart Miles at FreeDigitalPhotos.net