Higher Yields Come With Increased Risk
For the first time in 10 years, according to a recent report by Market Rates Insight, we’re seeing the average interest rate drop below 1 percent on checking, savings and other deposit accounts. You’re intimately aware of this fact if you’re trying to generate income or live off the interest from your savings or money market account. The issue applies to the short-term bond market, too.
If this interest represents your fixed income, you’re facing a reality of living on less and less each month. If you’re searching for short-term income investments, you’re probably feeling a growing sense of frustration, wondering whether your money may be better off under the mattress.
Without question, this situation is a serious problem. But you need to be aware of potential issues before you start chasing higher returns.
During your search for other options, you need to understand that if someone offers you a “safe” bond investment but promises higher yields or interest, you will be increasing your risk. In general, if you want to earn a higher yield, you are almost always going to take some sort of additional risk to do it.
There are really only two ways to get a higher yield, and both of them come with increased risk:
1. Go down in credit quality. In other words, you buy investments from lower-quality issuers. A bond is really just you lending money to someone else in exchange for an agreed-upon interest rate. If I lend to the shady neighbor to start a pawnshop, I will absolutely expect to get a higher interest rate than if I lend to the United States government. After all, there is clearly a greater chance that Mr. Pawnshop will not pay me back.
2. Tie your money up long term. Right now, things look bleak, with interest rates below 1 percent. So the investment that’s offering you 2 percent may look really appealing. So appealing, in fact, that you ignore that it ties up your cash for five years. This means that if rates perk back up a year or two from now, you’re locked in at 2 percent even if there are other options at that point that would offer a greater yield on a bond.
These decisions aren’t easy ones to make, and I understand how tempting it may be to take the leap to greater risk. But you could end up with much more serious issues if you fail to weigh the true costs of chasing after yield.
This sketch and post originally appeared in New York Times on September 7, 2010.