As if saving money wasn’t difficult enough, it’s now looking hazardous to boot.
Reports from the Investment Company Institute show that we are selling stocks and buying bonds. We’re also moving away from money market mutual funds. This is a big deal.
Money market mutual funds are a good example of the problem. This virtually risk-free investment medium had a net outflow of $65 billion in the first seven months of 2015. In the comparable period this year the outflow continued: $47 billion.
It’s the same with equity mutual funds. They went from $9.1 billion in new cash for the first seven months of 2015 to an outflow of $103.8 billion this year.
But bond funds gained new cash in both periods, $39.6 billion in the first seven months of last year, $47 billion this year.
While some of this money has moved to the lower cost funds available as exchange traded funds, it’s just some. As a group, we're betting that interest rates will be stable to lower. We’re assuming that fixed income investments will be safer than stocks.
Is that a good assumption? Let's check.
According to the Bloomberg website, a one-year Treasury yields about 0.57 percent. A two-year Treasury yields 0.73 percent and a five-year Treasury yields 1.12 percent. Now consider the trailing inflation rate. In August it was 1.1 percent. So savers who commit five years or less are receiving a yield lower than inflation--- with the added insult of having to pay taxes on it.
Things don’t look any better for savers willing to commit for longer periods. A 10-year Treasury now yields a whopping 1.58 percent. That means a $10,000 investment will yield $158 a year in interest, before income taxes.
How does this measure against a regular need to buy food? Here's a metric. The average retired worker received a $1,349.59 Social Security check in July. That's an annual benefit of $16,195. To earn that much in interest on a 10-year Treasury, the worker would need to have a million dollar nest egg--- $1,025,000, to be precise.
So, the income is pathetic. But the risk is close to heroic.
You can understand by considering what happens to the price of a bond when interest rates rise. Suppose you just bought a $10,000 Treasury with a 10-year maturity, yielding 1.69 percent. If interest rates remain stable, you’d collect $169 a year for 10 years. Then you’d get your $10,000 back.
It would be the same if interest rates rose and you held the investment to maturity. That might be a good thing, because if interest rates rise, your $10,000 investment would have a lower market value.
How can that be? Simple. If interest rates are higher a new investor might get, say, $300 a year on a $10,000 investment. So paying $10,000 for your $169 a year Treasury doesn’t look like a good deal. To compensate, buyers would offer a lower price.
How much lower? Low enough to receive a yield-to-maturity equal to the investment that yields $300 a year.
How big could your loss be if you had to sell?
Try these examples.
- If interest rates rise to 2.69 percent, your $10,000 Treasury would have a market value of $9,128. That’s a loss of $872, or five years of interest.
- If interest rates rose to 3.69 percent, your $10,000 Treasury would have a market value of $8,340. That's a loss of $1,660--- almost 10 years of interest.
- If interest rates rose to 4.69 percent, your $10,000 Treasury would have a market value of $7,627, a loss of $2,373.
And, by the way, holding to maturity isn’t a way to avoid loss. If you hold you’ll miss the opportunity to collect the higher yield the market is paying and others are collecting. (You can see this for yourself with any interest rate by going to the calcxml.com website for the value of a bond calculator.)
Are higher interest rates inconceivable? No at all. They are recent history, not ancient history. The 10-Year Constant Maturity Treasury was at 4.69 percent in August 2007. That's according to the FRED database at the St. Louis Federal Reserve Bank. Its record high was 15.84 percent, back in September 1981.
Interest rates may rise. They might also fall further. The only thing we know for certain is that the risk of “safe” fixed income investing is far, far larger than the reward.