As rates rise, where can you hide?
Investors have been on edge, wondering when the Federal Reserve will finally loosen its grip on long-term interest rates.
We fixed-income investors ought to be nervous. Rates jumped in May when the Fed began hinting at what it might do.
Interest rates are perilous to predict. But we may well be near the beginning of a miserable, bumpy, multiyear climb back toward more historically normal rates.
Since rising rates lower the value of bonds and bond funds, some nervous Nellies may be looking for a place to hunker down. So let's look at hiding places.
There are no good ones. If you want perfect safety of principal, you'll lose a little ground to inflation.
The best such hiding place is in the bank. Not the bank around the corner; look up in the cloud.
The best savings account rates in the nation tend be in online banks that solicit nationally over the Internet. GE Capital recently was offering an online savings account at 0.9 percent interest. American Express Bank was close at 0.85 and Ally Bank at 0.84.
Those yields are meanly skimpy, but they beat those at larger banks _ such as 0.03 percent at Commerce Bank or 0.05 percent at U.S. Bank.
Online banks also win on certificates of deposit: Nationwide Bank was offering 1.01 for a one-year CD, GE Capital Bank was at 1.05 with a $500 minimum deposit, and Ally Bank was at 0.94 percent with no minimum. You can find a good list at Bankrate.com.
Bank accounts offer safety of principal. Deposit accounts of up to $250,000 are federally insured. But with consumer inflation up 2 percent over the past year, bank savers are falling behind, even before accounting for taxes on interest.
"You're free from loss of principal, but not loss of buying power," said Greg McBride, senior financial analyst at Bankrate.com.
Other interest rates may rise, but rates on bank accounts aren't going anywhere soon. Bank saving rates react to two things: a bank's need for deposits, and rates on other short-term instruments.
Right now, banks are overflowing with depositors' money. Loan demand is growing, but not fast enough to consume the great piles of depositors' cash sitting in the banks. Banks don't need your money all that much.
Meanwhile the Federal Reserve is pledging to hold short-term rates low until 2015.
All of that means continued measly payouts on bank accounts. "We're looking at a good 18 months before substantial improvement," McBride said.
So, what are the alternatives?
Money-market mutual funds are the traditional refuge of Wall Street. They provide instant liquidity _ you can move in and out with a click or a phone call, or by writing a check. But the yields are nearly nothing _ 0.01 percent.
By law, the funds must invest only in highly rated, highly liquid short-term debt. That makes the principal very safe, but not perfectly so. In the 2008 financial crisis, the government stepped in to prevent a run on money funds after a single fund suffered a minor loss.
Unless you're planning to actively trade stocks and bonds, you're better off in a bank.
Other low-risk investments might do better, but all involve some risk of principal loss.
Ultra-short bond funds invest in securities that mature within a year or so. That short horizon limits the loss as rates rise, but interest yields are weak. For instance, Fidelity Conservative Income Bond has a 30-day SEC yield of 0.3 percent.
Investors use "duration" to measure risk of rising interest rates in bond funds. A duration of 1 means that a fund will lose 1 percent of its share price if interest rates rise 1 percentage point. It will gain 1 percent in price if rates fall 1 percentage point. Fidelity Conservative Bond has a duration of 0.4 percent, making it conservative indeed.
Still, the rise in interest rates this year has drained nearly all the profit for ultra-short investors. Their year-to-date return averages 0.1 percent, according to Morningstar.
Again, you would have been better off at the bank.
You could also buy individual bonds. A three-year A-rated corporate bond recently averaged a yield of 2.6 percent. Hold it to maturity and you'll get the face value of the bond.
But sell it before then and you might get more or less than you paid _ and individual investors tend to get lousy prices on bonds.
The problem with holding individual bonds is the lack of diversification. Most of us can't invest in enough companies to dilute our risk if one company fails.
The best advice may be to limit your hunkering to money you'll need in the next few years. At the moment, the best place for that may be the bank.
For the rest, take the long view. In today's environment, you need to take risk to have any hope of gain at all. So pick a mix of stock and bond funds that won't keep you up worrying at night, and cross your fingers.
(Jim Gallagher: email@example.com)