Certificate of deposit holders need new plan

by Stephen Butler

Returns on certificates of deposit are so low as to be laughable if the consequences for retirees were not so disastrous. Last week's column pointing out that the missing money could be as much a $400 billion a year, prompted a reader to call me and ask what I thought she might do. It goes without saying that we can't wait around for the government or politicians. They're too intimidated by their Wall Street minders to roll us right back to the days of effective regulation. Lobbying, which would be called corruption anywhere else, stands in the way of serious reform.

So, we're alone with our money, and here's what our best course of action could be. For generating income, I have consistently recommended a mix of Vanguard's Short Term Corporate Bond fund, their GNMA fund, and their High Yield Corporate Bond Fund. The returns in the form of monthly dividends deposited into retiree checking accounts have remained relatively constant for the past 10 years, and capital values are about what they were 10 years ago. Investing today at current prices, Short Term pays 2.34 percent, GNMA pays 3.37 percent and High yield is paying 7.05 percent. A three-way even mix would average about 4.5 percent.

What's confusing to investors is that bond prices can rise and fall even if the interest payments remain constant. To illustrate how bonds work, we will buy a five-year bond that sells for $1,000 and that pays (to keep the arithmetic simple) a 10 percent interest rate. This means that the bond is effectively a loan that will pay the investor $100 per year and return the original $1,000 at the end of five years.

The 10 percent rate of return when the bond was brand new was what the going market rate for five-year loans happened to be at the time we purchased the bond. Over the five-year holding period, however, the market rate for new bonds sold to other people fluctuated between 8 percent and 12 percent because of different events taking place in the economy that affected interest rates in general.

Because bonds are priced every day, just like stocks, the price of a previously-issued bond can go down if interest rates in the market go up. Why? Because our old bond (in this example) paying just $100 per year has to compete with a brand new bond that someone can buy that will pay them $120 per year. On the open market, the bond's price falls to about $800 so that our $100 annual interest payment, (the coupon) would equal a 12 percent return on the $800 purchase price.

On the other hand, if interest rates in the market had dropped to 8 percent, a brand new bond would only be paying $80 per year. We have a valuable old bond that pays $100, so we could actually sell our bond for about $1,200. Our $100 annual interest equals about an 8 percent return on $1,200) and effectively makes us a $200 profit if we sell at that point. As our bond approaches its maturity - the point at which we get the $1,000 back - the fluctuation in price goes away regardless of what is happening in the interest rate market. We are too close to the end point to matter.

Bond mutual funds, like those mentioned earlier, need to be purchased carefully right now, because low interest rates have made all the bonds momentarily more valuable. Of the three mentioned above, go mostly with the Short Term Corporate and income average by investing regular amounts over time into the GNMA fund. Go easy on the High Yield Corporate Fund until we see where future interest rates are heading.

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