Chasing high yield is risky business

Donald Saltz

July 10, 1992|By Donald Saltz

At the beginning of this month, a lot of high-yielding municipal bonds were called in, years ahead of their maturity dates, and the bondowners were repaid their principal along with a 2 1/2 or 3 percent premium to help compensate for the early call.

The result was that investors had their pockets stuffed with money but no reasonably safe way to reinvest it to get the 11, 12 or 13 percent yields that their old bonds had been earning.

Keep in mind that those bonds had been issued a decade ago when interest rates were especially high.

What the investors have been doing in the past few days is to reinvest in other municipal bonds or funds of these bonds, generally paying half the former interest rates -- and even less.

Similar scrambling has really been going on for months as interest rates appeared to savers to be ridiculously low for the basic forms of saving -- certificates of deposit as well as money market and regular savings accounts -- rates in the 3 to 4 percent area and, when considering taxes, well under the annual level of inflation.

At one time, tax-free money market accounts kept pace with inflation, but they don't now with their yields of less than 3 percent.

On the surface, this moving around of money seems smart, but there's danger of loss that has nothing to do with the quality of the investments.

The potential danger is in fluctuation of interest rates. Right now, rates are declining, thus boosting the share prices of bond mutual funds.

This week, for example, high-yield, tax-free bond funds were a saver's dream. They've been gaining a few cents each day while returning relatively strong yields of 6 1/2 to 6 3/4 percent.

In just three weeks the T. Rowe Price Tax-Free High-Yield Fund has gained 1.5 percent, unusually strong for a municipal bond fund and especially this one which usually doesn't fluctuate more than 3 percent in an entire year.

The same is true of practically all bond funds, taxable and tax-free.

Their price gains are in response to sharply lower interest rates.

But the reverse is also true. Although interest rates aren't likely to rise soon, when they do, the share prices of bond funds will decline and savers should be aware of this.

Many investors have been going the stock route, settling for better-yielding stocks.

The favorite category is utility stocks, which benefit doubly from lower interest rates -- they can borrow for less and their dividend yields are more meaningful.

However, should the interest rate trend simply be reversed and, without little upward movement, utilities' share prices could suffer sharp losses.

Investors who buy into these stocks now are doing so when the share prices could be near their highs, so there is risk.

Many stocks, utilities included, are selling at risky price-earnings ratios.

Investors who buy utility stocks for their yields but who ignore the price-earnings ratios when they are historically high are endangering their investment funds.

Even highly regarded Potomac Electric Power Co., which serves more than half of Montgomery and Prince Georges counties, is selling at a high for several years.

The yield of 6 percent is attracting investors who might be ignoring Pepco's earnings, which have been sluggish for years.

The stock could be vulnerable to a slight turn in interest rates.

The same is true for Baltimore Gas & Electric, whose shares have reached into new high territory and which yields 6 percent.

Earnings have been relatively weak for years, and it is earnings, not interest rates, that should be spurring a stock's price.

A sense of panic enters the picture when extremes occur, such as the sharply lower interest rates that now prevail.

Investors should take a longer-term outlook and realize that trends change.

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