More Ways to Lock in Higher Yields in Case Interest Rates Fall
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For the rest of us, this is a personal financial on money, how IT works, how to invest in and how to live without worrying about IT. I'm your host, David stein. Today is episode four.

Sixty four is titled more ways to lock in higher yields in case interest rates fall. We're currently doing a listener survey for listeners of money for the rest of us, and we ask listeners what they want to hear about. And one of the leading suggestions is to do more multipart series over several episodes that take a deeper dive into particular topic.

That's what this episode is. We discussed a number ways to lock in higher yields. In last week's episode. We want to continue that discussion in this week's episode and share some addition ways that we can lock in higher yields.

Now why would you want to do that? One of the questions we got from one of our plus members as well. If we think intestate are going to fall, then why don't we just purchase a longer term bond fund or etf and benefit from the Price appreciation if interest rates do?

For the reason is we're not sure they're going to fall and we wanted protect ourselves in case interest rates rise in last week up. So we reviewed the three primary drivers that determine interest rates. The first is the expectation for future short term interest rates, and that's tied to the central bank policy rate in the us.

That the fed fun rate as investors believe a central bank will be lowering its policy rate in the future, that can put downward pressure on its a rates. The second driver was inflation expectations. When market participants believe inflation rates are going up or expected inflation that can put upward pressure on interest rates and when they believe inflation will be falling, that and put toward pressure.

The third element was the term premium, additional compensation, investors demand for uncertainty regarding inflation and what central banks will do this. Term premium is also catch all from the impacts of supply and demand. We ve seen interest rates fall about zero point nine percent since last four, and about half of that was due to the term premium declining and the rest was due to expectations that short term interest rates would fall, the policy rate as well as lower inflation expectations.

Last week in the economist, there was an article that shared a pretty fascinating graph. IT was a graph of the federal funds rate target over time going back to two thousand seven. And that shows the policy rate, which right now is at five point two five percent.

But off that main boarded line, there are all these other little lines going off the right. Sometimes they go up, sometimes they go down. And those lines reflect the future expectations of short term rest rate at that given point time.

I include the chart in our weekly insider guide emails. It's hard to explain in audio, but the conclusion of IT is that market participants are not very good at predicting interest rates throughout the the fed raising of the policy rate over the past two years. The expectation of market participants was that would never get anywhere near as high as that eventually got.

And now they're anticipating that the polis rate will fall, but their expectations for how much you would fall there is over time. And so when we talk about lacking in higher yields is because we don't know with interest rates are going to fall or whether they are going to yes. And were content that we can get four percent of five percent lock in that return over the next five years or so.

We think about if we really believe intestate you're onna fall, then we would go out and buy some type of longer term bond etf. But because interest rates go up and down, the longer the maturity, the particular bonder etf or the interest rate sensitivity as measured by what's known as duration, that can really impact the return. For example, the I shares twenty plus year treasury board etf, the ticker is T L T.

It's down four percent this year because interest sites you've gone up a little bit. It's it's very sensitive to changes in interest rates. In twenty twenty two, that fund lost thirty one percent.

IT gained a return positive two point eight percent in twenty twenty three. I only mention that because of a concept that we've discussed a number of times on the show was known as volatility drag. When IT comes to bonds to fix income, the best estimate of the future return is the current yield to maturity.

Or if it's a bone that's likely to be called IT, it's the yelled to worse we that last week, but that's for sort of bins that are short to intermediate term. When IT comes to longer term bonds, it's not as good of an estimate because of the volatility of longer term bonds. For example, ten years ago, december twenty thirteen, the year to mature are the yield on twenty year by which is prevalent to what T, L, T, invest in.

That yield was three point seven percent. If we look at them, the average return just verging out the return over the past decade of T, L, T. That's three point four percent. So it's pretty good proxy for just looking at the average return.

If an asset class is an overly Violet tile, the average return will be fairly close to what's known as the geometric return or the analia ed return here with T, L, T. If we look at the annualize return, the geometric return over the past decade, it's two point one percent. It's over a percent lower than the starting yield for twenty year bonds and over percent lower the average return over the past decade.

Why is the geometric return so much lower or at least a percent lower? It's because of the volatility, because the the fund lost thirty one percent and twenty twenty two. And when you lose such a large amount and then you have to gain even more to recover those losses, the mathematics of IT waged down the overall return so that the geometric return is less than the are athletic return.

And one way to estimate that is, you can take half of the variance. So the variance is the square of the standard deviation. The standard deviation of the measure of volatility for T, L, T, over the past decade has been fourteen percent.

We square that, we get the standard deviation, which is two percent, and then we can take half of that, which is one percent. And that's an estimate of how much lower the geometric return will be relative to the erotic metic return. And IT has been around one percent just because of how volatile t has been.

And so when we think about oh, if you're definitely going to fall, i'm going to go out very long duration. Yes, they might fall, but they might not. And there are times when you when you should rise and those longer duration funds have large losses, and that can lead to bigger volatility drag.

Now I do think it's more likely that interest rates will fall in the coming years. I don't know how quickly, but inflations coming down the federal reserve at some point will reduce policy rate and not can even that will happen this spring. The term premiums is always a wild card just because of the show amount of treasury bonds and need to be issued in the U.

S. Due to the premium. But not everyone has a this view. I was at our annual H O A meeting recently, and one of our neighbors recommended a financial youtube r that I won't mention his name, but this youtube r was convinced interest rate or are going to rise as the federal reserve cut its policy rate. And he gave two examples in the seventies when that happened.

Now there were more examples when the fed cut its policy rate and interest rates fell. But there are times when they don't. I don't want to mention this youtube, because is logic for why interest IT would rise even as the fed cutch its policy rate was floored.

He correctly pointed out that banks, when they lend, they create new money. They lend money into existence, something we've discussed numerous times. They deposit the loan amount in the borrower's account, and they offset that when they learn receivable on their books.

This youtube, though, said that because the policy rate was going to be lower, that the government was going to borrow more money, and because they were borrowing more money, U. S. Federal government, that would increase amount of treasures outstanding, and that would lead to more money, more money creation, a bigger money supply, and that would lead to higher inflation.

And as result, interest rate would go up because inflation was higher. And the problem with that is, well, that is true, that large increases in the money supply can and have had to higher inflation, particularly if there are capacity constraints in the economy. Issuing government bonds doesn't increase the money supply.

Let's take a step back what happens when the federal government borrowed money. And first off, they're boring money because they're running a deficit. So they've spent more money than they have received in tax revenue.

And so spending that money, sending IT to the checking account, individuals such, say, social security payments that act on the phone, would increase the money supply. But when the government issues the bond, whoever buys that bond takes some of their cash. There are money, and they buys the band that soaks up that money that flow out into the economy from the government spending.

They completely offset, on the one hand, the government spending money. On the other, they're issuing a bond. They're taking back money.

Whoever bought the bond, the exception to this is if the federal reserve or another nation central bank is buying those domestic bonds with newly created money, this is known as quantitative of easing. And IT is what LED to the huge jump in the money supply, a six trillion dollar increase in the us. That spend our biggest inflation in over thirty years, but that's not where we are today.

The federal service is reducing their baLance sheet in quantitative tightening, and that is reducing the money supply, something we've talked about in recent episodes. So bad is not true that if the feed reserve cuts, es policy rate and U S. Government issues more or treasury bills that that will automatically lead to higher inflation because of of a larger money supply.

We don't know. Rich could go up. They could go down. I were thinking about locking in those higher yields if we want. Last week, we discuss two ways to do that.

We can and purchase individual bonds or we can purchase bullet etf, which are etf that have a set maturity and they hold a basket of individual bonds that mature on a specific date. won't. Visit that today, but here are three additional options.

The first are bank certificate of deposits, the second is fixed, the unities, and the third is zero coupon treasury bonds. Most of us are familiar with certificates of deposit, the issued by banks or credit unions. They are for a fixed amount of time that say five years, and the investor receives interest.

The interest is credited to the the C. D. Sometimes the interest can go into another camp, typically to stays into the account.

The benefit of cds is they're insured by the government in the U. S. Is that F, D, I, C, the federal deposit insurance core can choose different length for for the cds.

Often there is an early withdraw penalty, but there is something called a broker city where you can get with your online broker in my cash, wab and theyll list out cds. And depending on the particularly criteria, sometimes i'll allow you to sell IT early without a penalty. But generally, traditionally, cds has been a penalty for selling early. And one of the chAllenges with cds is even though if that the interest is credited to the account, you know, so you have access to the cash you still tax each year on that interest.

I looked out on trap and and there are broke red cds or cds available there five years that are paying a yield of four point one percent so investor could go in and they could buy that city, the in the minimum might have been ten thousand dollars maybe, and they could lock you in a four point one percent, yelled. So that's one option. Another option.

Fixed annuities, these are sometimes called differ generalities or multiyear guarantee annuities. They have some similarities to certificates of deposits, but they are issued by insurance companies. They're not guaranteed by the federal government. But if you buy a fixed unity from a highly rated insurance company, the the likelihood of the insure not honoring the the unity is incredibly small, and most states have some type of insurance pool to protect against annuities that get defaulted on and is is incredibly rare. But still one can choose a highly rated fixed unity and choose different terms.

I focused on on five years in this website, so is easier to compare apples to apples, but I went to immediate annuity stock come and saw five years fixed unities for a plus plus rated insures, but had a yield of five point three percent over percent higher than certificates of deposit. One benefit of fixed the unities is the interest received each year, and that's added to the account that is not text to each year is suffering until the end of the contract. And if you buy what's called a non qualified fixed unity, which means you buy IT with after tax dollars when IT matures, then you pay tax on the the interest that was credited, but not until, in this case, the end five years.

There are some downsides to fix the unities. They can be complicated. They come with A A very lengthy e contract, a lot of which discusses well what to do at the end of the term. We've want to roll into another annuity or something like that.

Many people, people that invest in fixed uni ties, including some members of money for the restless, plus they just use some panel like cds, buy one for five years to hold IT pay attacks on the interest income at the end, and then decide what to do with those funds. But they do come with a fairly long contracting, and I can take thirty to forty five days to go through the paperwork and complete the process. This is not as simple as just buying a broker.

C, D, through your online broker, but the yellow are hire five point three percent for five year fixed annuities right now. The other chAllenge with fixed annuities says if its a non qualified annuities purchased with aftertaste, if the annual I then decides to exit the contract direly before matures. So I say year three for five year fixed ity not only do does that investor oh the tax on the interest, but there's an additional ten percent penalty on that interest because there's a tax to feral element of fixed uist and the federal government in the U.

S scourie sort of accessing that cash too early. They wanted the unity to mature. So that seems a little agreement, but that those are the rules should exit a fixed annuity early, which means there's a difference between, let's say, A C D and a fixed unities to lock and yield ds that way compared to some of the options we discuss last week.

You don't have the optionality with an annuity or A C D in the same way you do an ability or an individual. If interest rates fall, you own an individual bond, you can sell IT, it's very liquid and capture that game. Do the same with the ability.

Tf, very, very liquid. Cds are not necessarily as liquid, and you don't get the Price appreciation. If interest rates fall in the interview, me, just get your interest.

And there are impediments to accessing that interest earlier. There could be penalties, not always, but there could be with cds and and there certainly is in early withdraw penalty with A A fixed unity. Before we continue, let me pause and share some words from this week.

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You buy the bond at at a five year zero coupon bond. You buy IT at a discount. And then at the end of the term, you get the principle back and there's an an computed interest rate.

So you're not having to deal with the cash low worries of bigging out how to reinvest interest payments because you just buy IT at a discount. IT appreciates to the principal value and the return is up being essentially that starting yelled to maturity. I hadn't really thought about this, but IT turns out U.

S. Government doesn't actually issue zero coupon bonds. All the bonds of the issue have a coupon payment and pay interest. It's the financial industry that creates zero coupon bonds. They'll take a thirty year treasury bond and they split up the different payments.

And that's why these zero coupon bonds, sometimes called treasury strips, with strips standing for separate trading of registered interest and principle of securities. With these strips, every interest payment and every final principle payment is its own security. So it's a manufactured security by taking apart a traditional thirty year treasury bond.

I went on trip and I can buy a five years zero coupon bond, seven year different maturities, but recognize that, that's not original bon issued by the government. It's A A portion of IT. And so IT would still very, very low risk, which is why if we look at the yields on zero coupon bonds basically are similar to the comparable treasury about you, the one that pays dividend.

So the world the maturity is the same. And just that with the the strip is your cuba. There is no interest payment. There's still taxes to be paid though, because of the computed interest, the government still want its money. So even though you're not receiving casual used to have to pay interest on the appreciation as the discount narrows over time.

The only reason really to purchase a zero coupon von versus a omo treasury is you don't want to receive any cash flow. You wanna have to worry about reinvesting that cash flow. The other reason people invest in strips is because they believe interested are going to fall a regular coupon bearing bond and a strip of the same maturity, let's say, both twenty years the strips gone to have a higher duration is gonna much more interested, sensitive because there are any cash flows except for that final payment.

And so investors, speculators really will sometimes invest in strips as a way, really get a big bang if interest rates fall. So we've looked at over the past two episodes a number of ways to lock in higher yields because we're not sure interest rates are going to fall. We know what drives interest rates.

We know that market participants are are lousy at forecasting the direction of interest rates so that we have a choice. We can purchase a number of different options to luck and higher yields. We decide we want to do bullet D, T, F.

There's the investor bullet shares, twenty, twenty and nine corporate bond. T, F. So IT matures in five years.

IT tickers, B, S, C, T, these are investment grade corporate bond, so there is credit risk there. But typically investment grade bonds to default risk is incredibly low. The S, C, C, yids is four point eight percent.

That's an estimate. The return of investing this over the next five years, we could do a five year treasury bond. Right now, they yelled on a five year treasury bond. So a very low default risk is four percent. For both the ability T, F and the treasure bind your text each year on the interest received.

We could do with five years zero coupon treasure bond as a strip that's also yielding four percent right now, but the same as nominal treasuries, but you're not getting any cash low even though you're still paying taxes on the computed interest. We could buy a five year treasury inflation protection security. The urban now one point eight percent, the investor earn one point eight percent plus whatever the inflation rate is.

In the case of tips, your tax on any interest you receive as well as the increase in the principal amount due to the increase inflation. So with that increase in principal amount, you're not getting cash low, but you to all taxes on IT. But the benefit of the tips is, you know you're going to get the one point eight percent and then you'll get whatever inflation will be.

We could buy a five year agency bond. You should buy an agency of the federal government, such as a federal homeland bank. Last week, we discussed how many bonds are all they can be redeemed early.

And so we want to own a caliber bond that has a lower coupon rate, stated interest rate compared to prevAiling rate. So it's less likely to be called so a five year federal homeland bank agency bond that has a coupon payment at one point six five percent. So not likely to be called in the next five years that yield a maturities four point three percent.

So all those options, there will be some benefit if interest strates fall because of the optionality of selling IT and taking the game because of the Price appreciation liquid options, we could get a five C D four point one percent is what they're paying right now. You can't really get out early, but you do get the fd I C government insurance or we could do a more leg work, more paperwork and lock in the higher eld of all the options with a fixed annuity through an insurance company. Yields right now about five point three percent.

They're not liquid, but you don't have to pay taxes on the interest income until the fixed the mature. And then there's municipal bonds, which we discuss some last week, three point one percent yield to maturity. Right now for a triple a municipal year, low coupons are not likely to be called, and then we can calculate a tax equivalent yelled for that of by dividing that three point one percent l to maturity by one minus the tax rate, if in individuals in the thirty five percent federal income tax bracket, because the interest income is tax exam, that's equivalent to run a four point eight percent yield, similar to the the ability to so many options.

That's why I took two weeks to go through them all. What do you do? I use a variety of ways, and I think most investors can have a variety options in the portfolio.

I bought individual bonds. I still owns some bond closed and funds, but mutual funds, I have a variety of them. It's important. Understand the the the ins and out of each option the tax consequences ces of IT, if it's in a tax account. So that's why we've gone through a number of options.

There's not one best choice is just really helpful to have different tools that we can use to lock in higher yields for a portion of our bond portfolio and and maybe we keep some that can benefit from, I drop an interest rates that happen. So i'm all about multiple return drivers in our portfolio. We can decide how complicated we want to be, how many holdings, but we should at least understand what the options are and what is that.

That drives interest rates, as we've discussed and have the humility to realize. We don't know whether rates will fall or rise from here. Market professionals don't know. But what we do know is what yields are now.

And if for content with that, we can decide to lock in a yield because we're happy to earn four to five percent right now over the next five years or longer. That episode for sixty four. Thanks for listening. You may be missing some of the best money for the rest of us content. Our weekly insider guide email newsletter goes beyond what we cover in our podcast episodes and helps elevate your investment journey with information that works best in written in visual formats.

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