Chapter 7
In This Chapter
Getting the most from a bank
Selecting the right type of bonds for you
Choosing among individual bonds and bond mutual funds
Understanding other lending investments
Lending investments are those in which you lend your money to an organization, such as a bank, company, or government, which typically pays you a set or fixed rate of interest. Ownership investments, by contrast, provide partial ownership of a company or some other asset, such as real estate, that has the ability to generate revenue and potential profits.
Lending investments aren’t the best choice if you really want to make your money grow. However, even the most aggressive investors should consider placing some of their money into lending investments. The following table shows when such investments do and don’t make sense.
Consider Lending Investments If … |
Consider Ownership Investments When … |
You need current income. |
You don’t need or want much current income. |
You expect to sell within five years. |
You’re investing for the long term (seven to ten-plus years). |
Investment volatility makes you a wreck, or you just want to cushion some of the volatility of your other riskier investments. |
You don’t mind or can ignore significant ups and downs. |
You don’t need to make your money grow after inflation and taxes. |
You need more growth to reach your goals. |
Lending investments are everywhere — through banks, credit unions, brokerage firms, insurance companies, and mutual fund companies. Lending investments that you may have heard of include bank accounts (savings and certificates of deposit), Treasury bills and other bonds, bond mutual funds (and now exchange-traded bond funds), mortgages, and guaranteed-investment contracts.
In this chapter, I walk you through these investments, explain what’s good and bad about each, and discuss situations in which you could consider using (or not using) them. I also tell you what to look for — and look out for — when comparing lending investments.
Putting your money in a bank may make you feel safe for a variety of reasons. If you’re like most people, your first investing experience was at your neighborhood bank, where you established checking and savings accounts.
Part of the comfort of keeping money in the bank stems from the fact that the bank is where your parents may have first steered you financially. Also, at a local branch, often within walking distance of your home or office, you find vaults, security-monitoring cameras, and barriers in front of the tellers. Most of these things shouldn’t make you feel safer about leaving your money with the bank, however — they’re needed because of bank robberies!
Some people are consoled by the Federal Deposit Insurance Corporation (FDIC) insurance that comes with bank accounts. It’s true that if your bank fails, your account is insured by the U.S. government up to $250,000. So what? Every Treasury bond is issued and backed by the federal government — the same debt-laden organization that stands behind the FDIC. Plenty of other equally safe lending investments yield higher returns than bank accounts.
Any investment that involves lending your money to someone else or to some organization, including putting your money in a bank or buying a Treasury bond that the federal government issues, carries risk. Although I’m not a doomsayer, any student of history knows that governments and civilizations fail.
With the continued growth of the online world, you can find more and more banking options online. Of particular appeal are higher-interest online savings accounts. The best of them do pay higher interest rates than their brick-and-mortar peers and money market funds.
Online banks don’t generally have any or many retail branches; they conduct most of their business over the Internet and through the mail. By lowering the costs of doing business, the best online banks may offer better account terms, such as paying you higher interest rates on your account balances. Online banks can also offer better terms on loans.
Online banking is convenient, too. It’s generally available 24/7. You can usually conduct most transactions more quickly on the Internet, and by banking online, you save the bank money, which enables the bank to offer you better deals.
Technology allows you to do more and more banking online. But remember to protect yourself and your money. You need to put on your detective hat when investigating online banks and be ready to do some searching for the best and safest deals. Never pick a bank simply because you saw one of their ads or because you know a coworker who uses that bank. These sections tell you what you need to do to evaluate an online bank and how to make the most of banking online.
So what do you look for in an online bank? First you need to select a bank that participates in the U.S. government-operated Federal Deposit Insurance Corporation (FDIC) program. Otherwise, if the online bank you chose fails, your money isn’t protected. The FDIC covers your deposits at each bank up to $250,000.
Other than savings accounts, banks also sell certificates of deposit (CDs). CDs are an often overused bank investment — investors use them by default, often without researching their pros and cons. The attraction is that you may get a higher rate of return on a CD than on a bank savings or money market account. And unlike a bond (which I discuss in the “Why Bother with Bonds?” section later in this chapter), a CD’s principal value doesn’t fluctuate. CDs also give you the peace of mind afforded by the government’s FDIC insurance program.
The reason that CDs pay higher interest rates than savings accounts is that you commit to tie up your money for a period of time, such as 6, 12, or 24 months. The bank pays you 1 to 2 percent and then turns around and lends your money to others through credit cards, auto loans, real estate loans, business loans, and so on. The bank then charges those borrowers an interest rate of 10 percent or more. Not a bad business!
When you tie up your money in a CD and later decide you want it back before the CD matures, a hefty penalty (typically about six months’ interest) is shaved from your return. With other lending investments, such as bonds and bond mutual funds, you can access your money without penalty and generally at little or no cost.
In addition to penalties for early withdrawal, CDs yield less than a high-quality bond with a comparable maturity (for example, two, five, or ten years). Often, the yield difference is 1 percent or more, especially if you don’t shop around and simply buy CDs from the local bank where you keep your checking account.
High-tax-bracket investors who purchase CDs outside of their retirement accounts should be aware of a final and perhaps fatal flaw of CDs: The interest on CDs is fully taxable at the federal and state levels. Bonds, by contrast, are available (if you desire) in tax-free (federal and/or state) versions.
Because bank accounts generally pay pretty crummy interest rates, you need to think long and hard about keeping your spare cash in the bank.
You can, if you so choose, keep your checking account at your local bank. But you don’t have to. I don’t, because I use a money market fund that offers unlimited check writing at a mutual fund company. I also don’t keep my extra savings in the bank.
Instead of relying on the bank as a place to keep your extra savings, try money market funds, which are a type of mutual fund that doesn’t focus on bonds or stocks. Money market funds offer a higher-yielding alternative to bank savings and bank money market deposit accounts.
Money market funds, which are offered by mutual fund companies (see Chapter 8), are unique among mutual funds because they don’t fluctuate in value and because they maintain a fixed $1-per-share price. As with a bank savings account, your principal investment in a money market fund doesn’t change in value. If you invest your money in a money market fund, it earns dividends (which are just another name for the interest you’d receive in a bank account).
The best money market mutual funds offer the following benefits over traditional bank savings accounts:
Banks can get away with paying lower yields because they know that many depositors believe that the FDIC insurance that comes with a bank savings account makes it safer than a money market mutual fund. Also, the FDIC insurance is an expense that banks ultimately pass on to their customers.
Another useful feature of money market mutual funds is the ability they provide you to write checks, without charge, against your account. Most mutual fund companies require that the checks that you write be for larger amounts — typically at least $250. They don’t want you using these accounts to pay all your small household bills, because checks cost money to process.
However, a few money market funds (such as those that brokerage cash management accounts at firms like Charles Schwab, TD Ameritrade, Vanguard, and Fidelity) allow you to write checks for any amount and can completely replace a bank checking account. Do keep in mind that some brokerage firms hit you with service fees if you don’t have enough assets with them or don’t have regular monthly electronic transfers, such as through direct deposit of your paycheck or money transfer from your bank account. With these types of money market funds, you can leave your bank altogether because these brokerage accounts often come with debit cards that you can use at bank ATMs for a nominal fee.
Just as you can use a money market fund for your personal purposes, you also can open a money market fund for your business. I have one for my business. You can use this account to deposit checks that you receive from customers, to hold excess funds, and to pay bills via the check-writing feature.
Higher yields, tax-free alternatives, and check writing — money market funds almost sound too good to be true. What’s the catch? Good money market funds really don’t have a catch, but you need to know about one difference between bank accounts and money market mutual funds: Money market funds aren’t insured (however, they were for a one-year period during the 2008–2009 financial crisis).
As I discuss earlier in this chapter, bank accounts come with FDIC insurance that protects your deposited money up to $250,000. So if a bank fails because it lends too much money to people and companies that go bankrupt or abscond with the funds, you should get your money back from the FDIC.
The lack of FDIC insurance on a money market fund shouldn’t trouble you. Mutual fund companies can’t fail, because they have a dollar invested in securities for every dollar that you deposit in their money market funds. By contrast, banks are required to have available just a portion, such as 10 to 12 cents, for every dollar that you hand over to them (the exact amount depends on the type of deposit).
The only money market funds that did “break the buck” didn’t take in money from people like you or me; in one case, the fund was run by a bunch of small banks for themselves. This money market fund made some poor investments. The share price of the fund declined by 6 percent, and the fund owners decided to disband the fund; they didn’t bail it out, because they would have been repaying themselves. In another case, a money market fund that took in money from institutions declined by 3 percent.
Conservative investors prefer bonds (that is, conservative when it comes to taking risk, not when professing their political orientation). Otherwise-aggressive investors who seek diversification or investments for shorter-term financial goals also prefer bonds. The reason? Bonds offer higher yields than bank accounts, usually without the volatility of the stock market.
Bonds are similar to CDs, except that bonds are securities that trade in the market with a fluctuating value. For example, you can purchase a bond, scheduled to mature five years from now, that a company such as the retailing behemoth Wal-Mart issues. A Wal-Mart five-year bond may pay you 5.25 percent interest. The company sends you interest payments on the bond for five years. And as long as Wal-Mart doesn’t have a financial catastrophe, the company returns your original investment to you after the five years is up. So in effect, you’re loaning your money to Wal-Mart (instead of to the bank when you deposit money in a bank account).
But bonds that high-quality companies issue are quite safe — they rarely default. Besides, you don’t have to invest all your money earmarked for bonds in just one or two bonds. If you own bonds in many companies (which you can easily do through a bond mutual fund or exchange-traded fund) and one bond unexpectedly takes a hit, it affects only a small portion of your portfolio. And unlike CDs, you can generally sell your bonds anytime you want at minimal cost. (Selling and buying most bond mutual funds costs nothing, as I explain in Chapter 8.)
Investing in bonds is a time-honored way to earn a better rate of return on money that you don’t plan to use within the next couple of years or more. As with stocks, bonds can generally be sold any day that the financial markets are open. Because their value fluctuates, though, you’re more likely to lose money if you’re forced to sell your bonds sooner rather than later. In the short term, if the bond market happens to fall and you need to sell, you could lose money. In the longer term, as is the case with stocks, you’re far less likely to lose money.
Here are some common situations in which investing in bonds can make sense:
Bonds differ from one another according to a number of factors — length (number of years) to maturity, credit quality, and the entities that issue the bonds (the latter of which has tax implications that you need to be aware of). After you have a handle on these issues, you’re ready to consider investing in individual bonds and bond mutual funds.
Unfortunately, due to shady marketing practices by some investing companies and salespeople who sell bonds, you can have your work cut out for you while trying to get a handle on what many bonds really are and how they differ from their peers. But don’t worry. In the following sections, I help you wade through the muddy waters.
Suppose you’re considering investing in two bonds that the same organization issues, and both yield 7 percent. The bonds differ from one another only in when they’ll mature: One is a 2-year bond; the other is a 20-year bond. If interest rates were to rise just 1 percent (from 7 percent to 8 percent), the 2-year bond may decline about 2 percent in value, whereas the 20-year bond could fall approximately five times as much — 10 percent.
If you hold a bond until it matures, you get your principal back, unless the issuer defaults. In the meantime, however, if interest rates rise, bond prices fall. The reason is simple: If the bond that you hold is issued at, say, 7 percent, and interest rates on similar bonds rise to 8 percent, no one (unless they don’t know any better) wants to purchase your 7-percent bond. The value of your bond has to decrease enough so that it effectively yields 8 percent.
Bonds are generally classified by the length of time until maturity:
Most of the time, longer-term bonds pay higher yields than short-term bonds. You can look at a chart of the current yield of similar bonds plotted against when they mature — such a chart is known as a yield curve. Most of the time, this curve slopes upward. Investors generally demand a higher rate of interest for taking the risk of holding longer-term bonds. (To see the current yield curve, visit my website at www.erictyson.com.)
In addition to being issued for various lengths of time, bonds differ from one another in the creditworthiness of the issuer. To minimize investing in bonds that default, purchase highly rated bonds. Credit-rating agencies such as Moody’s, Standard & Poor’s, and Fitch rate the credit quality and likelihood of default of bonds.
The credit rating of a bond depends on the issuer’s ability to pay back its debt. Bond credit ratings are usually done on some sort of a letter-grade scale where, for example, AAA is the highest rating and ratings descend through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on. Here’s the lowdown on the ratings:
Why would any sane investor buy a bond with a low credit rating? He or she may purchase one of these bonds because issuers pay a higher interest rate on lower-quality bonds to attract investors. The lower a bond’s credit rating and quality, the higher the yield you can and should expect from such a bond. Poorer-quality bonds, though, aren’t for the faint of heart, because they’re generally more volatile in value.
I don’t recommend buying individual junk bonds — consider investing in these only through a well-run junk-bond fund.
Besides varying in credit ratings and maturity, bonds also differ from one another according to the type of organization that issues them — in other words, what kind of organization you lend your money to. The following sections go over the major options and tell you when each option may make sense for you.
Treasuries are IOUs from the U.S. government. The types of Treasury bonds include Treasury bills (which mature within a year), Treasury notes (which mature between one and ten years), and Treasury bonds (which mature in more than ten years). These distinctions and delineations are arbitrary — you don’t need to know them for an exam.
Treasuries pay interest that’s state-tax-free but federally taxable. Thus, they make sense if you want to avoid a high state-income-tax bracket but not a high federal-income-tax bracket. However, most people in a high state-income-tax bracket also happen to be in a high federal-income-tax bracket. Such high-tax-bracket investors may be better off in municipal bonds (explained in the next section), which are both federal- and state-income-tax-free (in their state of issuance).
Municipal bonds are state and local government bonds that pay interest that’s federal-tax-free and state-tax-free to residents in the state of issue. For example, if you live in California and buy a bond issued by a California government agency, you probably won’t owe California state or federal income tax on the interest.
The government organizations that issue municipal bonds know that the investors who buy these bonds don’t have to pay most or any of the income tax that’s normally required on other bonds — which means that the issuing governments can pay a lower rate of interest.
Companies such as Boeing and Johnson & Johnson issue corporate bonds. Corporate bonds pay interest that’s fully taxable. Thus, they’re appropriate for investing inside retirement accounts. Lower-tax-bracket investors should consider buying such bonds outside a tax-sheltered retirement account. (Higher-bracket investors should instead consider municipal bonds, which I discuss in the preceding section.) In the section “Understanding bond prices,” later in this chapter, I show you how to read price listings for such bonds. If you buy corporate bonds through a mutual or exchange-traded fund, an approach I advocate, you don’t need to price such bonds.
Remember that mortgage you took out when you purchased your home? Well, you can actually purchase a bond, naturally called a mortgage bond, to invest in a portfolio of mortgages just like yours! Many banks actually sell their mortgages as bonds in the financial markets, which allows other investors to invest in them. The repayment of principal on such bonds is usually guaranteed at the bond’s maturity by a government agency, such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae) or the Federal National Mortgage Association (FNMA, also known as Fannie Mae).
Convertible bonds are hybrid securities — they’re bonds you can convert under a specified circumstance into a preset number of shares of stock in the company that issued the bond. Although these bonds do pay taxable interest, their yield is lower than nonconvertible bonds because convertibles offer you the potential to make more money if the underlying stock rises.
The U.S. government offers bonds called Treasury inflation-protected securities (TIPS). Compared with traditional Treasury bonds (which I discuss earlier in this chapter), the inflation-indexed bonds carry a lower interest rate.
The reason for this lower rate is that the other portion of your return with these inflation-indexed bonds comes from the inflation adjustment to the principal you invest. The inflation portion of the return gets added back into principal. For example, if you invest $10,000 in an inflation-indexed bond and inflation increases 3 percent the first year you hold the bond, your principal would increase to $10,300 at the end of the first year.
What’s appealing about these bonds is that no matter what happens with the rate of inflation, investors who buy inflation-indexed bonds always earn some return (the yield or interest rate paid) above and beyond the rate of inflation. Thus, holders of inflation-indexed Treasuries can’t have the purchasing power of their principal or interest eroded by high inflation.
Because inflation-indexed Treasuries protect the investor from the ravages of inflation, they represent a less risky security. However, consider this little known fact: If the economy experiences deflation (falling prices), your principal isn’t adjusted down, so these bonds offer deflation protection as well. As I discuss in Chapter 2, lower risk usually translates into lower returns.
You can invest in bonds in one of two major ways: You can purchase individual bonds, or you can invest in a professionally selected and managed portfolio of bonds via a bond mutual fund or exchange-traded fund (see Chapter 8.)
In this section, I help you decide how to invest in bonds. If you want to take the individual-bond route, I cover that path here, where I explain how to decipher bond listings you find in financial newspapers or online. I also explain the purchasing process for Treasuries (a different animal in that you can buy them directly from the government) and all other bonds. If you fall on the side of funds, head to Chapter 8 for more information.
Unless the bonds you’re considering purchasing are easy to analyze and homogeneous (such as Treasury bonds), you’re generally better off investing in bonds through a mutual fund or exchange-traded fund. Here’s why:
On the other hand, investing in bonds through a fund is cost-effective. Great bond funds are yours for less than 0.5 percent per year in operating expenses. Selecting good bond funds isn’t hard, as I explain in Chapter 8.
Business-focused publications and websites provide daily bond pricing. You may also call a broker or browse websites to obtain bond prices. The following steps walk you through the bond listing for PhilEl (Philadelphia Electric) in Figure 7-1:
If you want to purchase Treasury bonds, buying them through the Treasury Direct program is the lowest-cost option. Call 800-722-2678 or visit the U.S. Department of Treasury’s website (www.treasurydirect.gov).
You may also purchase and hold Treasury bonds through brokerage firms and mutual funds. Brokers typically charge a flat fee for buying a Treasury bond. Buying Treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold. Selling Treasury bonds held through Treasury Direct requires you to transfer the bonds to a broker.
Purchasing other types of individual bonds, such as corporate and mortgage bonds, is a much more treacherous and time-consuming undertaking than buying Treasuries. Here’s my advice for doing it right and minimizing the chance of mistakes:
Did you know what a subprime mortgage was before 2007, when stories of rising defaults were all over the news? Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default.
Of the money that you want to invest in bonds, don’t put more than 5 percent into any one bond; that means you need to hold at least 20 bonds. Diversification requires a good amount to invest, given the size of most bonds and because trading fees erode your investment balance if you invest too little. If you can’t achieve this level of diversification, use a bond mutual fund or exchange-traded fund.
Bonds, money market funds, and bank savings vehicles are hardly the only lending investments. A variety of companies are more than willing to have you lend them your money and pay you a relatively fixed rate of interest. In most cases, though, you’re better off staying away from the investments in the following sections.
Insurance companies sell and back guaranteed-investment contracts (GICs). The allure of GICs is that your account value doesn’t appear to fluctuate. Like a one-year bank certificate of deposit, GICs generally quote you an interest rate for the next year. Some GICs lock in the rate for longer periods of time, whereas others may change the interest rate several times per year.
But remember that the insurance company that issues the GIC does invest your money, mostly in bonds and maybe a bit in stocks. Like other bonds and stocks, these investments fluctuate in value — you just don’t see it.
Typically once a year, you receive a new statement showing that your GIC is worth more, thanks to the newly added interest. This statement makes otherwise-nervous investors who can’t stand volatile investments feel all warm and fuzzy.
The yield on a GIC is usually comparable to those available on shorter-term, high-quality bonds. Yet the insurer invests in longer-term bonds and some stocks. The difference between what these investments generate for the insurer and what the GIC pays you in interest goes to the insurer.
The high effective fees that you pay to have an insurer manage your money in a GIC aren’t the only drawbacks. When you invest in a GIC, your assets are part of the insurer’s general assets. Insurance companies sometimes fail, and although they often merge with a healthy insurer, you can still lose money. The rate of return on GICs from a failed insurance company is often slashed to help restore financial soundness to the company. So the only “guarantee” that comes with a GIC is that the insurer agrees to pay you the promised rate of interest (as long as it is able)!
In the section “Mortgage bonds,” earlier in this chapter, I discuss investing in mortgages that resemble the ones you take out to purchase a home. To directly invest in mortgages, you can loan your money to people who need money to buy or refinance real estate. Such loans are known as private mortgages or second mortgages, in the case where your loan is second in line behind someone’s primary mortgage.
Private mortgage investments appeal to investors who don’t like the volatility of the stock and bond markets and aren’t satisfied with the seemingly low returns on bonds or other common lending investments. Private mortgages seem to offer the best of both worlds — stock-market-like, 10-plus percent returns without volatility.
One broker who also happens to write about real estate wrote a newspaper column describing mortgages as the “perfect real estate investment” and added that mortgages are a “high-yield, low-risk investment.” If that wasn’t enough to get you to whip out your checkbook, the writer/broker further gushed that mortgages are great investments because you have “little or no management, no physical labor.”
You know by now that a low-risk, high-yield investment doesn’t exist. Earning a relatively high interest rate goes hand in hand with accepting relatively high risk. The risk is that the borrower can default — which leaves you holding the bag. (In the mid- to late 2000s, mortgage defaults escalated significantly.) More specifically, you can get stuck with a property that you need to foreclose on, and if you don’t hold the first mortgage, you’re not first in line with a claim on the property.
The fact that private mortgages are high risk should be obvious when you consider why the borrower elects to obtain needed funds privately rather than through a bank. Put yourself in the borrower’s shoes. As a property buyer or owner, if you can obtain a mortgage through a conventional lender, such as a bank, wouldn’t you do so? After all, banks generally give better interest rates. If a mortgage broker offers you a deal where you can, for example, borrow money at 10 percent when the going bank rate is, say, 6 percent, the deal must carry a fair amount of risk.
Also recognize that your mortgage investment carries interest rate risk: If you need to “sell” it early, you’ll have to discount it, perhaps substantially if interest rates have increased since you purchased it. Try not to lend so much money on one mortgage that it represents more than 5 percent of your total investments.