The Ultimate Survival Guide for Savers Who Want to Earn More (or at least Some) Interest
There is no free lunch, but some lunches are tastier than others.
The long-term decline in U.S. interest rates since the early 1980s (see above) has been great for borrowers, including homeowners with mortgages to refinance, businesses needing more capital, and our profligate government. However, it has presented a substantial challenge for the nation’s savers, especially for retirees that had planned to earn a positive, and safe, inflation-adjusted return on their savings.
In response, many savers, unsatisfied with earning a 0.01% interest rate in bank savings accounts or money market funds, lower than the increase in the annual cost of living, have looked for riskier assets where they could earn a higher return. This investing phenomenon is called “reaching for yield.”
There is a huge middle-ground to choose from that is more attractive than the 0% interest-bearing saving account but less risky than the stock market
Reaching for Yield
Reaching for yield behavior in not limited to individuals. It has been documented among bond mutual fund managers trying to earn higher returns than their competitors, insurance companies attempting to maximize returns while meeting regulatory requirements, and underfunded pension funds striving to make promised payments to beneficiaries. Warren Buffett counsels against doing it (check out the short video below), arguing that investors in fixed income products need to adapt to lower interest rates by cutting their expenses, rather than trying to artificially raise returns to generate enough cash for the lifestyle they had previously expected to have.
In this post, I discuss THREE options for investors looking to get a higher rate of return. In financial markets there are no “free lunches”, the investor must always “pay” for a higher return by accepting more risk. However, there is a huge middle-ground to choose from that is more attractive than the 0% interest-bearing saving account but less risky than the stock market.
Three Options for Savers
The Name is Bond…Savings Bond
The government is subsiding savings bonds to the tune of $350 per person per year.
A few weeks ago, a colleague of mine told me that U.S. savings bonds are a great investment opportunity right now, providing a 3.54% annual interest rate backed by the full faith and credit of the U.S. government. “How is this possible?” I asked. I had only heard of these bonds as gifts for children. “There has to be a catch.”
Well, there is definitely a catch. You can only invest $10,000 per individual per year (plus an additional $5,000 using a federal income tax refund) and they can’t be resold, so the federal government is selling them to you for less than they would cost on the market but NOT allowing you to immediately resell them at market price and pocket the difference. Given current prices, if a $10,000 savings bond were trading on the market (assuming a one-year holding period), it would cost around $10,350. Therefore, the government is subsiding savings bonds to the tune of $350 per person per year.
Last week, Jason Zweig wrote a great article about savings bonds in the Wall Street Journal, describing their key advantages and drawbacks. One important advantage is that interest is not taxed at the state and local level. One drawback is that they can’t be redeemed before twelve months and if they are redeemed in less than five years, the investor forfeits the last three months of interest payments.
Still, for anyone currently looking to earn a higher interest rate on $10,000 than what a bank account or money market gives, without taking on extra risk, savings bonds are a no-brainer.
Municipal Bonds
Municipal bonds are issued by state and local governments, and unlike bonds sold by the federal government, there is a theoretical risk that the bond issuer will not be able to pay you back. Historically, municipal bond defaults have been very rare, with a five-year default rate of 0.08% (1 out of every 1200!) in the period from 1970 through 2019. Moreover, in the current climate where the federal government acts as an implicit guarantor of state and local government obligations, and after $350 billion dollars were recently sent to states and local governments, default risk looks extremely low.
The main advantage of municipal bonds is that the interest they pay is exempt from taxes. For wealthier investors in high-tax states that have marginal tax rates of over 50%, this means that the interest rate on municipal bonds needs to be more than doubled when comparing with other investments that are taxable.
The easiest way for individuals to purchase municipal bonds is through municipal bond mutual funds. For instance, the Vanguard Massachusetts Tax-Exempt Fund (which I own) has a distribution yield this year of around 2.3%. Now, this fund does hold some long-term municipal bonds which are subject to interest rate risk (the fund price drops when interest rates rise), but the 10-year Treasury bond, a taxable U.S. government bond with similar interest rate risk, currently pays a 1.6% interest rate and that yield only gets smaller after taxes.
In summary, unlike with savings bonds, you are definitely taking on risk when you buy municipal bonds, both credit risk that the issuer will run out of money to pay you back, and interest rate risk if you buy bonds with longer horizons. Still, they look attractive, especially for high-income savers who are willing to take a calculated amount of risk.
High-Dividend Stocks
Stocks that pay stable dividends each quarter are another potential tool for the yield-reaching investor. For instance, the Vanguard High Dividend Yield ETF, an exchange-traded fund which holds a well-diversified portfolio of stocks that pay high dividends, currently pays a 2.82% annual yield, and these dividends are taxed at a lower rate (15% for most investors) than interest earned on bonds.
Dividend-paying stocks are still stocks, so they are much riskier than the two types of government-issued bonds described earlier. Their price declines during market downturns: The Vanguard High Dividend Yield ETF had returns of -15% in October 2008 and -14% in March 2020. They also sometimes reduce or eliminate their dividends, although this is not likely to matter for investors that invest in a well-diversified portfolio of dividend-paying stocks through a mutual fund or ETF.
Of course, you can create a synthetic dividend from any stock or portfolio of stocks by selling a certain percentage of your holdings every time you want to get some cash. One advantage of buying actual dividend payers is that they are stable mature companies with significant cash flows, and research has consistently shown that such stocks have higher total returns than growth stocks.
Avoid Real Estate Investment Trusts (REITs)
One caveat to investing in a portfolio of high-dividend stocks is that you should AVOID the temptation to reach for yield through real estate investment trusts (REITs). REITs are obligated to distribute at least 90% of their taxable income to shareholders which is why their dividends look great compared to those of other stocks. However, there is no expectation that the current dividend yield will persist over time. REITs paying a dividend that looks extremely generous, for example greater than 10%, are a very high risk to cut that dividend in the near future. Furthermore, unlike stock dividends, REIT “dividends” are usually taxed at the same tax rate as ordinary income, making them an even less attractive option.
Conclusion
We are at the end of a multi-decade decline in interest rates which has made it harder for savers to collect enough interest to even beat the rate of inflation. The only two responses are the Warren Buffett approach of cutting one’s living expenses or “reaching for yield.” While each investor should decide the right approach based on their own risk appetite, horizon, tax rate, etc., the three options discussed above merit consideration. There is no free lunch, but some lunches are tastier than others.
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