By Rosilyn H. Overton, CFP, CRPS
It always happens — when the stock market is at its lows, and bond interest rates are at their lows — the public gets interested in buying bonds. It is almost always a bad idea, and it’s bad now because interest rates are at nearly 40-year lows. While it may be a good time to start nibbling at the stock market, many of you are so traumatized by the last few years that you cannot consider investing in the stock market again.
If you are afraid of the stock market, are in your late-50s or older, and want to get better interest rates than you can get in the bank, buy fixed annuities that are not subject to market risk on principal, that automatically reinvest your interest and give you an option to make partial withdrawals while you hold them.
What happens when you buy bonds at a time like now, when interest rates are at lows? When interest rates are low, bond prices are high, and when interest rates rise, bond prices will fall. This means that if you buy a seven- or 10-year bond now, and two or three years from now interest rates are higher, you won’t be able to sell it for what you paid for it.
Let’s take an example. Suppose you buy a seven-year bond right now at a price of $100 — this means that the face value and the price you pay are the same, so when it matures in 10 years you will get your investment back. Let’s also suppose that three years from now you have some kind of emergency, and you need to cash it in, but in the meantime, interest rates have gone up 2 percent, from a current rate of about 3.5 percent for a 10-year corporate bond to 5.5 percent for a bond due to mature in 6 1/2 years from that future time. What has happened to the price of your bond? The price will be around $89.19 or less — a loss of more than 10 percent from your original price. This means that a $10,000 bond would get you only about $8,919 on the open market, before the markdown of 1-2 percent that is the cost of selling it.
A 10-year brokered CD right now would actually give a slightly higher yield than a corporate bond — about 3.8 percent through a brokerage firm if you shopped the national market, did not care about which bank it was held at, and had at least $10,000 to invest. However, these are not CDs that you can cash in for a fixed penalty, but are traded like bonds, so you would have the same market drop in value that you would for the corporate bond.
We love the local banks and think that they do a great job of taking care of day-to-day cash savings and mortgages. Plus, their CDs give you a guarantee of principal. However, when we checked CD rates at one of the largest local banks, the best rate I could find on March 10 was 2.71 percent on an 84-month CD. Given that it is a three-year-shorter maturity than the corporate bonds we looked at, this is a pretty good rate. This CD has an advantage, however, in that if you had to cash it in, you would only take a penalty of about three months interest. It’s better than a bond, for sure, but it is still such low interest that after inflation you hardly make anything. That’s why a fixed annuity seems to make the best sense, with one caveat — you need to be age 59 1/2 before you withdraw the money to avoid a nasty 10 percent income tax surcharge.
Currently, for instance, from one New York insurance company, there are annuities that will offer you 4.1 percent guaranteed for four years, with no penalty after that date for withdrawal, and a minimum interest rate of 3 percent, possibly more, after the four-year period is up. Five-year rates are 4.3 percent, and six-year rates are slightly higher. For New York State residents, these annuities are protected against default by the New York Insurance Guarantee fund, up to a maximum of $500,000. There is no market value adjustment if you have to withdraw before the guarantee period is up (although there is a 6 percent penalty for total withdrawals in excess of 10 percent), and you can withdraw up to 10 percent of what you deposited each year without a penalty from the company. Other insurance companies have similar deals, with the rate and period guarantees varying slightly. Here everything is known in advance. If you need a small amount of cash, the 10 percent free withdrawal might be enough. The company guarantees that you will always at least get back what you invested, so the worst that happens is that you lose the interest that you have earned.
Interest rates are likely to rise again if the economic situation improves. Since bond prices go down when interest rates rise, consider a fixed annuity if you wish to keep your money safe, need some liquidity, and won’t be taking money out before you turn 59 1/2.
Rosilyn H. Overton, CFP, CRPS is branch manager and principal at Mid-Atlantic Securities, Inc., member, NASD & SIPC, in Little Neck. She is a past chairman of the Financial Planning Association of New York. She can be reached at 718-631-4000.
