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Fixed Income Investments in a Low Yield Environment

September 3rd, 2013

By Josh Chittenden, CFP®

On August 8th, 2013, I searched “CD Yields” on Bankrate.com. On this day, the average 3 month CD yielded 0.15%, while the average 5 yr. CD yielded 1.5%. According to Bankrate.com, in 2007 the average 5 year CD yield was above 3.5%! This is a significant decline between the Great Recession of 2007 to now. This drastically lowered yield has large implications for investors. So, how did we get here and what should an investor do in this market?

 

The Federal Reserve (Fed) has taken extraordinary measures to keep interest rates low since the Great Recession in 2007. When economic troubles began in 2007, the Fed started by lowering the Fed Funds Rate. By December 8th of 2008 the Fed had dropped the rate to a historic low of 0.00%. Due to the economy’s continued struggle, in late 2008 the Fed implemented the first of what would be three Quantitative Easing (QE) measures, meant to help spur the economy. The first QE is now known as QE1, “The purchase over time of a variety of high grade securities, including agency mortgage backed securities (AMBS), agency debt, and long term government bonds…”1 In October 2010 the Fed announced a second round of Quantitative Easing known as QE2. QE2 was restricted to long term government bonds and smaller in scale than QE1. The third round of Quantitative Easing, QE3, consisted of the Fed stating that they would purchase up to $85 billion of mortgage backed securities per month via an open-ended bond purchasing program designed to keep interest rates low. QE3 is still in effect today. As of August 14th the Federal Reserve’s ownership of U.S. debt was over $2 trillion dollars.  Most of this debt was a result of the recent quantitative easing measures.

 

These unprecedented actions by the Fed have lowered the yields of all types of fixed income investments (CDs, muni-bonds, corporate bonds, etc.).  While this is great for the person who wants to finance a house, car, or any other item, the low interst rate environment is not as beneficial for fixed income investors.  For example, if a couple has $500,000 saved at today’s rates (5 yr. CD yields 1.5%), this couple will receive $7,500 in interest for the year. At that rate, an investor isn’t going to grow their wealth very quickly.  This has caused many investors to react and look at taking on more risk, hoping to get a better return.  The feeling gets compounded when we see the stock market performing well.  We start feel like we are missing out on returns.

 

It is important to remember that investing can cause emotional reactions and keeping these emotions in check can be difficult. Acting on those feelings is emotional investing.  Investment decisions should be based on long-term goals and objectives, not emotions.  When investment decisions are made with emotions, mistakes are made. Going from having zero money in equity holdings to all of your money in equity is too risky in most cases and usually results in more damage than gain.

 

Even with low yields, fixed income is an important part of any investor’s portfolio.  It can help mitigate the volatility in stocks and provides diversification benefits.  If a change is needed, make sure it is goal driven, not emotionally driven.  Only increase your equity positions as much as you need in order to reach a defined goal.  Chasing returns by moving in and out of equity markets is a long term losing proposition.  If you are concerned about your situation it would be prudent to have a discussion with your advisor to see if making any changes would be best for you in the long term.

 

1. http://www.federalreserve.gov/Events/conferences/2012/cbc/confpaper1/confpaper1.html

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