A young man asked about a good place to put $1,000. He will need the money for school expenses in a year and doesn't want to worry about it in the meantime. With interest rates about as low as they're going to get before heading back up, a one-year certificate of deposit, or even a six-month CD, risks locking in today's low yields while overall rates are rising.
When he was shown current yields on money-market mutual funds -- about 5.5 percent -- the young man's reaction summed up many investors' dismay:
"That's all?" he asked.
Yes, that's all. There's no law that says 9 percent interest rates are required, particularly on such short-term investments as money-market funds, money-market deposit accounts and CDs maturing in a year or less. This fact is about to become painfully clear to even more people this fall. A crop of CDs will mature and decisions must be made about whether to roll them over into new CDs or put the money elsewhere. Since those CDs were purchased, the decade-long era of relatively high short-term interest rates has ended.
"The '80s were unique," Stephen Gaber, chief operating officer of Mesirow Financial Corp., a money management firm in Chicago, says. "You got paid for staying short. Those days are over."
However, like people who report the latest Elvis sighting, some investors keep trying to recapture the past. In doing so, financial advisers warn, they may be reaching for the highest possible yields without understanding the risks.
For example, Brian Mattes, vice president at the Vanguard Group, a mutual fund firm based in Valley Forge, Pa., says that many investors have been calling lately and asking for the highest-yielding "guaranteed" investment. When they're told that Vanguard's Ginnie Mae fund, for example, is earning about 8.6 percent, they immediately ask for a prospectus and an application, without waiting for an explanation of the risks. If interest rates rise, the portfolio -- bonds backed by the Government National Mortgage Corp., or Ginnie Mae -- will decline in value.
While the federal government guarantees that the principal on ,, bonds will be repaid, it does not guarantee the interest rate.
Also, Ginnie Mae funds have a special risk of their own, known as "prepayment risk." With 30-year fixed-rate mortgages at or below 9 percent in most of the country, many homeowners are refinancing their mortgages into the lower rates. As they do, the average yield of the Ginnie Mae portfolio falls. In the last big wave of refinancing, in the mid- to late 1980s, yields on Ginnie Mae funds fell as much as a third in a few months.
These are the sort of risks many "yield junkies" don't understand, John Markese, executive vice president and director of research at the American Association of Individual Investors, says. AAII members often call the association's headquarters in Chicago to ask about a "high-yield" investment they've read or heard about from a broker or financial adviser.
"Unfortunately, many of those calls are after the fact," Mr. Markese says. "They've already sent in the money."
Historically, short-term investments tied to interest rates have yielded about 2 percent to 3 percent more than inflation. At the current inflation rate of 4 percent to 5 percent, depending on where you live, that would make a 7 percent to 8 percent yield reasonable.
Returns like that aren't available from most money-market funds and CDs, of course, but it is possible to get there with a moderate increase in interest-rate risk, especially if the money won't be needed for a few years.
Of course, if you only have $1,000 to invest and safety is important, don't worry about yield. You don't have enough to spread among several investments, and you don't want to be concerned about a loss of principal if interest rates rise. So pick one good place, like a money-market mutual fund, and wait for interest rates to go up again.
If you're really concerned about safety, make it a U.S. Treasury money fund. Yields on these funds are usually, but not always, about a tenth of a percentage point less than an ordinary money fund, but the securities are guaranteed by the U.S. Treasury.
If you do have enough money to diversify among a few fixed-income investments -- say, $5,000 to $10,000 -- you can increase the overall yield by putting money in two or three places.
The current yield on short-term bond funds, for example, is about 7.6 percent. The least-volatile of these funds invest in top-rated corporate bonds maturing in five years or less. The average maturity of bonds in the T. Rowe Price Short-Term Bond Fund, for instance, is about 2 1/2 years, Steven Norwitz, a Price spokesman, says.
Another possibility, where the underlying securities are even safer, is an intermediate-term or long-term U.S. Treasury bond fund. The yield on the Vanguard Long Term U.S. Treasury Bond Fund is now about 8.1 percent, but that higher return is the reward for taking on more risk in the future, if overall interest rates rise.