After the latest move by the Federal Reserve to cut interest rates, investors may find it even harder to earn extra income off their savings.
The Fed lowered the federal funds rate to 1% on Oct. 29. Though occasionally the rate has hit that level—most recently in 2004—the fed funds rate hasn't been lower than 1% since 1958.
Market observers weren't sure how much immediate effect the Fed move would have: The yields on safe U.S. Treasury securities are already very low. Many hope interest rates eventually fall on home mortgages and consumer debt, because that would stimulate the economy. But those hopes rest more on restoring confidence to the financial system first. "If financial institutions aren't willing to lend to each other, not much is going to leak through to consumers," says Ward McCarthy of Stone & McCarthy Research Associates.
Looking for Yield in Stock Dividends
The rock-bottom federal funds rate is a sign of the times in credit markets: As investors have piled into Treasuries and other relatively safe hiding places, it is harder to get a decent payoff for your money.
One option, of course, is the stock market, where many equities pay out a quarterly dividend. General Electric (GE), for example, pays out a 7% dividend yield, while Bank of America (BAC) pays a 6.2% yield.
Yet these high yields also reflect serious worries about these companies' prospects. GE or BofA shares have tumbled all year. If that continues, equity investors could lose more from the falling stock price than they earn from their quarterly dividends.
Reaching for Yield
The credit markets are usually preferred by conservative investors trying to protect themselves from risk while still generating income. But here, too, the risks are everywhere.
Corporations issue bonds, but the higher the interest rate the bond pays to its holders, the riskier it tends to be. "The yield is where the risk is," says Marilyn Cohen, chief executive of Envision Capital Management. "One of the reasons the economy got in trouble is people were really reaching for yield in the last few years," says Steven Medland, a partner at TABR Capital Management in Orange, Calif. "They were getting paid very little to take that extra risk."
High-risk bonds are paying higher yields these days, but the risks are also so much more obvious than in the past. In corporate bonds, "There is some risk in there because some of these corporations are going under," says Marshall Groom Jr. of Groom Financial Advisory in Richmond, Va. The risk of default and bankruptcy rises depending how serious the recession gets.
International Bonds Can be Risky
Still, says McCarthy, bonds of "some pretty high-quality companies" are trading at wide spreads, meaning their yields are far above those of the safest government bonds.
International bonds can also be risky, but this is an area where it might make sense to find a bond manager you trust, Groom says. The manager can find the right balance between risk and reward. Groom recommends the T. Rowe Price International Bond Fund (TRIBX) to his clients.