The more you risk, the more you make
In congressional hearings this week, Federal Reserve Chairman Benjamin Bernanke said the central bank would keep short-term interest rates near zero for the foreseeable future. This is good for borrowers. Not so good for savers.
How do you get a decent yield? By taking on more risk. This is why junk bonds have become popular. But you may wonder if junk bonds are a good idea. Could be.
The economy is sluggish at best, and the Fed has kept rates low to try and keep the economy inching along. Low rates let companies and consumers refinance older, more expensive loans. And low rates help companies borrow for expansion, although few are taking out new loans these days.
If you’re looking for a safe, high-yielding investment, however, you’re just out of luck. The average money market mutual fund yields 0.04 percent or $4 a year for every $10,000 you invest. The top-yielding one-year bank CD pays 1.55 percent.
If you’re trying to get more interest from your investments, you have two ways to do it. The first is to lock up your money longer. To get higher yields, you have to take on even more risk, which means investing in corporate bonds. These are long-term, interest-bearing IOUs. The company will pay you a set amount of interest until the bond matures, which is when you’ll get your principal back. The risk is that the company will go bankrupt before your bond matures.
The rip is that there isn’t much return on corporate bonds either. High grade corporate bonds yield about 1.32 percentage points more than comparable Treasury securities.
To get really high yields, you have to take considerably higher risks and invest in junk bonds, which are high-yielding loans to companies with poor credit risks. But what are the risks with these?
There is a risk of default. The peak default rate for junk bonds was 14.5 percent last November, and it was 6.3 percent in June. There’s also a risk of loss. The average junk bond lost 30 percent last fall.
But the reward is that the average junk bond is currently yielding about 8.43 percent.
The prognosis for the economy, according to many experts, is that it will creep along in a slow growth period. The good news about the recession, relative to junk bonds, is that it cleaned out the weakest junk bonds, so the ones that are left are the “good” ones. Relatively few new junk bonds are coming to market, so as demand increases, junk prices should rise.
However you choose to invest, do so carefully, and don’t be afraid to get the advice of a financial adviser or trusted friend. The only stupid question is the one you don’t ask.