CDs and bonds carry their own sets of risks

The premise of investing is to get a return appropriate for the risk. The return comes from income, capital appreciation and, if applicable, tax advantages.

Simply stated, but not easily determined, is figuring the return and the risk level, primarily but not exclusively, volatility risk and risk of capital loss.

Some investments “target” a return; some investments have a ‘history” of returns (as in the U.S. equity market long term rate of return has been 8 percent); some are contractually obligated to produce a specific return but the idea is that the return element is quantified — either generally or specifically and in hard copy or mental notation — by the investor at time of investing.

For the past five months, the U.S. equity market has been, at best, highly unpredictable and, at worst, undergoing a meaningful correction or starting another bear trend. When the U.S. equity market is in a predictable and positive phase (as in the 1990s), risk is not front and center; the magnitude of return is the topic of conversation. When folks are losing money, the analytic and emotional focus turns to understanding and quantifying the investment risk.

The risk side of this investment equation is much more difficult to nail; every seasoned investor knows this. When entering an investment, characterizations minimizing risk are often used, such as: “a no-brainer”; “ a quick in and out”; or “a steady return.” Somehow, some way, these same rock solid investments can: require rocket science, turn into a long term play, and necessitate a roller coaster’s harness to endure the volatility ride.

Besides the loss and volatility risks, there is liquidity risk, interest rate and financing risk, loss of purchasing power, time risks — the list is extensive.

All of this has been a long preface to get us to the present. We are clearly in uncertain economic times. As such, the pendulum has swung to a much narrower focus: risk management, preservation of capital, getting your money back — call it what you like.

Secondarily, the focus is to generate income.

Where have the masses historically gone in prior recessions to accomplish these joint goals? They have done to the safe haven of CDs. In prior recessions, the CD returns were adequate in absolute and inflation adjusted terms — not the best, but adequate. Just a few short years ago, CD rates of 4-5 percent were available.

As CDs are currently offering nil and as the equity market has been down to sideways (and definitely herky-jerky), the typical non-institutional investor has been moving into bonds in droves. The money flowing into government and corporate bond funds is astronomical. Investors are seeking a safe haven and yield higher than a CD.

Rates for 30-year Treasuries have fallen from 4.85 percent in early April to 3.69 percent (August 29), as prices for these bonds have been bid-up. People wanted to own them and the sellers were able to get higher and higher prices. As the prices go up, the yield on current price drops; of course, the coupon rate remains the same.

Could bonds go higher in price? Absolutely there could be more return. For example, a 30-year Treasury with semiannual payments and a 4 percent coupon priced at par or $100 would trade at $126 if rates fell to 2 percent. (By way of comparison, the 30-year Treasury yield was 3.69 percent as of close on Friday, Aug. 29.)

But absolutely Washington will do all possible to avoid Japanese-style deflation.

Those owning bonds need to consider the price risk if rates do rise. The aforementioned 30-year with semi-annual payments and a 4 percent coupon priced at par or $100 would trade at $80 if rates rose to 6 percent.

Will it happen tomorrow? No. Will it happen during the life of a 30-year bond? You betcha. So, unless you are planning to hold the bond to maturity even during inflationary times, you will have to develop a strategy for selling. And you might want to think about that strategy today.

At this juncture, there are several things investors who have moved heavily into bonds might want to consider and discuss with their investment adviser.

There are investment options other than a bond with a long maturity and a fixed rate coupon.

Options to consider include: senior secured, floating rate corporate debt where the floater is tied to LIBOR and the fixed spread is 5-6 percent (common financing terms for corporate credits which are not A credits), ownership of buildings leased by Social Security making U.S. guaranteed lease payments and/ or U.S. multinational equities with a long dividend history and a large foreign customer base.

In fact, last week, the yield on 20 of 30 of the Dow Jones Industrial stocks surpassed the dividend yield (3.5 percent) on U.S. 10-Year Treasuries. This is an anomaly not often seen. These companies have a history of growing their dividend. This is not a bullish case for U.S. equities; it is a relative valuation case.

It is important forn investor to understand their own risk tolerances even before they visit with an adviser. An adviser can’t tell you what thresholds of risk make you jittery or turn your life inside out. You need to be able to communicate some of these ideas. The adviser can work with you to structure a portfolio that better suits your risk tolerance. 

— Jeannette Rohn Showalter is a Sou thwest Florida-based chartered financial analyst, considered to be the highest designation for investment professionals. She can be reached at jshowaltercfa@yahoo.com.