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Don't Be a Lender
Lenders take a big risk on what their money will buy in the future.
Individuals have lent money in return for interest payments since money was invented. It was not until 1472, however, when what many consider to be the oldest bank in the world, the Monte dei Paschi di Siena in Italy, introduced the forerunner to the passbook savings account. The idea that banks could attract individuals' savings and keep track of their accounts opened the door to massive lending. In Renaissance times, bankers like the Medicis and the Fuggers, with their state-licensed money machine to attract depositors' money, grew immensely wealthy.
Beyond the Passbook
The passbook savings account remained the principal mode of individual savings for almost five hundred years, until the advent of computers after World War II. The first stage of the ongoing technological revolution was internal. Since banks and thrifts are nothing more than giant counting houses, it was easy to run the entire customer list past the computer each day. Earned interest, which had been posted once a month or once a quarter, could now be posted every night. It was a small step, to be sure, but in the merchandising of money, it was a fundamental innovation.
In 1969, an enterprising young executive of the Worcester Five Cents Savings Bankpetitioned the Massachusetts Banking Department for permission to offer a negotiable order of withdrawal account. A NOW account was, in effect, a computer-driven checking account that paid interest on the balance in the account. The executive knew he was skating on thin ice because at that time it was illegal for federally insured banks and savings and loans to pay interest on any monies on deposit for less than thirty days. However, the Massachusetts savings banks had their own deposit insurance fund, and Massachusetts law did not have the same tight restrictions as those that governed the federally insured banks and thrifts.
The state bank regulators gave his suggestion of using computers to track interest rates on checking accounts a frigid reception and turned him down cold, but the enterprising executive believed he had found a formula that could pry open the regulatory gate. He sued and he won. Thereafter, it became possible for state-chartered savings and loans to offer checking accounts that paid interest. For the first time since the advent of banking in the late 1400s, banks faced competition for the "free" money their customers had been forced to keep in non-interest-bearing checking accounts. As a result, Congress authorized NOW accounts for federally insured banks and savings and loans. Today, we take for granted that computers make money market accounts, certificates of deposits, NOW checking accounts, and an endless array of mutual funds possible. But what it all comes down to is that there are only two ways to put your money to work:as a lenderor as an investor.
A Lender Be
As Will Rogers said in the days of the Great Depression, "I'm not so concerned about the return on my money as the return of my money." Many people still feel that way. Their first objective is to keep their money safe. Therefore, lenders are willing to accept lackluster interest returns of 4 percent or less in exchange for the assurance that their original investment will be returned intact. The only decisions they have to make are the length of the deposit term and the interest rate they'll accept.
When you deposit money in a savings account, you are lending money to a bank in exchange for interest income. After the Great Depression and scores of bank failures, many lenders felt they were walking on a financial high wire. To give them the safety they required, Congress established the Federal Deposit Insurance Corporation (FDIC) to protect up to $100,000 per account. Banks and thrifts offer two basic instruments for earning interest income.
Money Market Accounts
Think of a money market account as a computerized passbook savings account. In the banking trade, they are called demand deposits. The main attraction is that you can make deposits and withdrawals any time you like. For this privilege you earn about 1 or 2 percent less interest than a fixed-term deposit. Moneymarket mutual funds -- while not federally insured -- have had the same safety record as bank money market accounts, and they pay as much as 1 to 2 percent more interest than bank money market accounts.
Are money market accounts and passbook savings good for banks? You bet they are! Over the past two decades, the banking industry has been sustained by the profits from ultra-low-yielding savings accounts squirreled away by worried or uninformed lenders. The good news -- not for lenders but for taxpayers -- is that without these billions of dollars of low-interest money, the recent financial bailout of banks and savings and loans would have cost a great deal more. Are money market accounts good for long-term investors? Probably not. Like millions of Americans, I started out with a passbook savings account. It held every penny of my entire wealth. My vision widened as I grew up and watched the numbers in my passbook increase. It turned out, however, that I would never get rich on 2 percent interest a year. I decided that when I had real money to invest I would put it to work in the stock market.
Fixed-Term Deposits
Insured certificates of deposit are term deposits. Terms are available from six months to as long as ten years. Like bonds, the longer the term, the higher the yield. Six-month insured CDs might yield 3 percent, but a five-year CD could yield well over 5 percent. To keep the money locked up inside the bank once you've made the deposit, the bank imposes a penalty for early withdrawal. The penalty is the loss of interest income for various periods, from ninety days to six months.
The problem with an insured CD is that if interest rates later rise, you are stuck with the lower yields until your CD matures, just as you would be with a bond. In your search for higher yields, you must withdraw the CD money and possibly pay the hefty early-withdrawal penalty. On the other hand, an insured certificate of deposit and money market account are the only interest-income investments where your principal is unaffected by changing interest rates. For example, if you deposit $1,000 in a one-year CD, you are assured of the return of the $1,000 one year later. With FDIC insurance, a bank failure along the way is no problem. Your money is safe. Or is it? In truth, the assured safe return of your money in the face of rising inflation puts your money at great risk. The shrinking dollar a lender gets back at the end of a CD term has less value in purchasing power than when it was invested in the first place.
Here's what I learned while talking to a farmer over a hay rake: If you earn only the inflation rate in interest, you can go directly to the poorhouse without passing go or collecting $100.
Let's say you deposit $10,000 in a one-year insured CD paying 4 percent interest. One year later, you'll get back $10,000, plus $400 interest, or a total of $10,400. However, the IRS does not love lenders. Eachyear the interest income you earn is taxed at your ordinary income tax rate. Let's say you're in a 28 percent federal and state tax bracket. The $400 of income can then shrink to $288, which leaves you with a net after-tax return of 2.9 percent. Now let say that over the past year inflation has risen 3 percent.
Here's how taxes and inflation can drain the real value out of your money:
You may feel good about yourself; you might have a lot of ideas about how you'll spend your money in retirement. But the fact is that over the years, in terms of real purchasing power, your saving account resembles a highway truck stuck in the mud going nowhere.
If you want to preserve the future purchasing power of your money, you must earn a long-term return substantially higher than inflation and taxes. That means dumping your low-yielding fixed savings accounts and investing in bonds, stocks, or equity mutual funds for their potential double-digit returns. What's that? You say you are scared to invest in the stock market?
The cold, hard fact is that you can't put your money to work without some risk.
Bond Basis Risk
If you've ever wondered why some people earn 3 percent in a money market account while others earn 7 percent on bonds, it's because the higher yields carry greater risks to principal if interest rates later rise. If you think this sounds a bit cold-blooded, you're right.
Over time savvy lenders, dissatisfied with the skimpy yields on money market accounts and certificates of deposit, have discovered that they can sometimes double their interest income with bonds or bond mutual funds. However, before you invest in a bond or bond fund, you need to know how bond basis risk can take a safe, guaranteed investment and turn it into a loss of principal. It's also important to understand that bond basis risk holds true for any bond -- government, tax-exempt municipal, high yield junk, or blue-chip corporate bonds.
In other words, if you ever want to become a savvy investor on Wall Street, you must understand that changes in interest rates can change the market value of any bond or bond fund. Without this knowledge, you can get clobbered when interest rates rise.
Bond basis risk means that bond prices and yields move in opposite directions. Take a recent newspaper story about the bond market. "Treasury bond prices posted sharp gains today, with the price of 30-year Treasury bonds rising 25/32 point, or $7.81 per $1,000 face value, while its yield fell from 6.30 percent to 6.24 percent."
Here's the classic example of how bond basis risk can affect your original investment: Suppose that two years ago you purchased a $1,000 bond paying 7 percent. Now, two years later, you decide to sell your bond, but the current interest rate has risen to 8 percent. You call your broker and discover that your $1,000 bond is now worth only about $945. You are told that you have a discounted bond. Anyone who buys your bond, which is paying only 7 percent when current interest rates are 8 percent, will receive a discount so that their new investment in your 7 percent bonds will effectively earn 8 percent. On the other hand, if interest rates have fallen to 6 percent after two years and you decide to sell your bond, you may be offered $1,055. You now have a premium bond, and a new buyer will pay the higher price to earn the bond's 7 percent yield when current rates are only 6 percent.
The degree of risk in bonds depends on how much interest rates move up or down and the maturity of the bond. The longer the maturity, the greater the risk of loss or gain. For example, a money market account has no bond basis risk because it keeps the maturities of its investments very short, often only sixty to ninety days, so that changes in interest rates do not affect its price. A dollar invested in a money market fund will always be worth a dollar, but a dollar invested in a five-year bond could lose about 4 percent of its market value if interest rates rise one full percentagepoint. That same one percentage point rate increase in a thirty-year bond, however, can reduce the market value of your bond by more than 11 percent.
When all the talk is about how much interest income you can earn, any bond fund that wants to attract investors' dollars reaches for the top yields. The only problem is that they rarely tell the investor that these funds can be very risky.
I'm always reminded of the lady who came up to me at a seminar and said, "Look here, Mr. Jorgensen, I invested $50,000 in some U.S. government bonds, but if I want to sell, they're worth only $46,000, and I can't afford to lose any money."
"Why did you invest in the bonds?" I asked in a soothing tone. "Because the friendly financial planner at the bank told me that the government bonds were guaranteed and they were safe. Besides, I could earn two percent more interest on my money."
What he didn't tell her was the downside -- that these higher-yielding bond funds carry greater risk as well as the potential for greater returns.
Bonds have an unseen danger. Most people don't know about it, and therefore it doesn't appear to exist.
High yields, however, are not the only factor to consider. Total return, which includes both bond price and yield, is a better measure of your investment's value. Total return is what you will earn at the end of the year, and it should include your interest income, plus or minus any changes in the market value of the bonds, and minus any salescharges and annual management fees. The following table estimates total returns on bonds with varying maturities. As you can see, the longer the maturity, the greater the fluctuation in total return.
Changes in Total Return Rates Rates Rates Interest Remain Go Up Go Down Rate Unchanged 1% 1% Short-term 3-year bond 4.5% +4.6% +2.7% +6.5% Intermediate-term 10-year bond 6% +6.1% 20.6% +13.4% Long-term 30-year bond 7% +7.1% 24.3% +21.0%
SOURCE: Fidelity Focus, published by Fidelity Investments. Copyright 1993, FMR Corp. Reprinted with permission.
The main point: Investing in bonds and bond funds can be risky, and even the pros lose their shirts. For example, on a $1,000 30-year bond, if interest rates rise one full percentage point, the annual total return, including the 7 percent interest earned, less the reduced market value of the investment, could be a loss of $43. On the other hand, if interest rates fall three full percentage points as they did in the first half of 2001, you can make a lot of money investing in long-term bonds.
While you may shop for an insured certificate of deposit based on yield, don't shop for fixed-income bonds or bond funds the same way. Remember, you're entering the land of the unpredictable, where half of Wall Street is looking to boost the value of your investment, and the other half is looking for fire-sale prices. Also, don't ever come into the bondmarket with the idea that you've got it all figured out. One way to cut your losses or boost your profits in bonds is by understanding the degree of risk you take before you invest. Money mangers say it's best to invest with maturities of about three to five years. Five years is where the yield curve tends to flatten out; after that, you run more risk than reward by grabbing the higher yields. Smart investors keep bond maturities short.
Let me say again that millions of fixed-income investors will lose money in the years to come because they don't understand the risk they are taking on so-called safe and guaranteed long-term bonds or bond funds. They look at the high advertised yield, listen to the slick pitch from the broker or financial planner on how well they will do with their money, think about the guaranteed and safe bonds, grab the deal, and then lose their shirts.
How ridiculous can this whole scenario of investing long-term become? Consider the Mickey Mouse bonds issued by the Walt Disney Company. For the first time since 1954, an investor had the opportunity to buy 100-year bonds. Yielding barely one percentage point more than a 30-year bond, the market value of these bonds, with a maturity of one hundred years, could fall like a rock when interest rates rise.
How Safe Is Safe?
The major problem that bond investors encounter is that they don't fully understand the words guarantee and safety as applied to bonds. Theguarantee stems from the fact that the bonds are unlikely to default. When you are told that a bond investment is "completely safe," it simply means that the bond issuer can be depended upon to pay the interest in a timely manner and the full face value of the bond at maturity. Guarantee and safety, however, say nothing about how the bond's market price will be adversely affected by rising interest rates.
Most people who invest in insured CDs believe that they are doing so without bond basis risk. The difference is that while the value of the CD always remains the purchase price, the CD could be worth less if you cash it in before maturity. The loss might be three months' or six months' worth of interest. If your account has not earned enough interest income when you make the withdrawal, the bank can dip into your principal to make up the difference. With bond income funds, you have no early withdrawal penalty; but to get your hands on your money you have to sell the fund at the current market price. If all that sounds a bit crazy, you're right. Most lenders put their money to work by walking into a bank, opening an account, filling out the paperwork, writing a check, and taking what interest income they can get. It's easy. The financial institution does all the investing for you. But these turbulent times don't call for following in the footsteps of the past.
Increasingly, savvy lenders think in terms of objectives. If you want to earn interest income, the important points are yield and safety.
Like a savings account, a bond buyer is lending the borrower the money. The borrower agrees to pay the bondholder a certain rate of interest (the coupon rate) each year until the bond matures. At maturity, the borrower repays the bond's face value and the bond is retired.
Many borrowers issue two kinds of bonds: secured and unsecured. Secured bonds are backed by the borrower's assets, like a home mortgage loan or car loan. If the borrower can't make the payments, the lender can seize the collateral. Unsecured bonds are not backed by any particular asset. They are like a credit card debt on which you have promised to repay.
Bonds can also be insured and guaranteed by a bond insurance company. The coverage is underwritten by private insurers and guarantees both the timely payment of interest and the repayment of the bonds at maturity. Most of the bond insurance is written by two organizations: American Municipal Bond Assurance Corporation (AMBAC) and Municipal Bond Insurance Association (MBIA). If the issuer defaults on the principal or interest payments, these insurers step in and make the payments.
Before you invest in any bond or bond fund, find out whether the bonds are secured or unsecured, and if the future repayments are insured by a bond insurance company.
Copyright © 2003 by Jim Jorgensen and Rich Jorgensen
Excerpted from It's Never Too Late to Get Rich: The Nine Secrets to Building a Nest Egg at Any Age by Jim Jorgensen, Rich Jorgensen
All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.
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