The Savings Game: Investing in fixed income alternatives

Richmond Times-Dispatch (VA)

The Savings Game

Many who invested in bond mutual funds with long maturities in 2022 were disappointed because total returns were negative.

When interest rates increase, the value of long-term bonds falls. Thus, for investors who thought that bond holdings would protect them, a fall in fund prices was disappointing, because in 2022 both bond prices and stock prices fell dramatically in value.

What will happen in 2023 is hard to predict. If the rate of inflation falls and the Federal Reserve starts to cut interest rates, then bond prices will increase and the value of bond funds with long maturities will increase, and equity prices will also rise. But no one can be sure if inflation will be controlled, and if inflation is not controlled better, then the Federal Reserve will not be taking steps to decrease interest rates.

At the beginning of 2022, investors who were looking for conservative investments that paid reasonable interest rates did not have very good options. The returns for Treasury bills, short-term CDs and money-market funds were very poor, in most cases less than 1%. Fortunately, for conservative investors, there are now much better alternatives for those looking for stable shorter-term conservative investments with reasonable returns.

For example, I wrote about a month ago that I had invested in Vanguard's Federal Money Market Fund, which was returning over 4% at that time. The return on that fund is now over 4.5%. Vanguard requires a $3,000 minimum investment for that fund. Money-market funds are very liquid, and you can sell shares quickly and convert them to cash whenever you wish. Fidelity also offers a comparable money-market fund.

If you invest in money-market funds, there are no tax advantages. However, currently you can also invest in municipal money-market funds that now earn almost 4%. Rates may not stay that high, but while they do, and if you are in a high tax bracket, you should consider this investment. For example, Vanguard offers such a fund, the Vanguard Municipal Money Market Fund (VMSXX), with a $3,000 minimum. Fidelity also offers a similar fund, the Municipal Money Market Fund (FTEXX), with no minimum and a similar yield. If interest rates fall, you can liquidate the funds immediately and invest in a traditional money-market fund or other conservative investment such as Treasury bills or CDs.

A 4% yield on a municipal money-market fund is equivalent to more than 6% for someone in the 35% federal tax bracket. Even though my tax bracket is lower, I have transferred some funds from my municipal bond investments into a municipal money-market fund.

Returns on CDs have increased dramatically since the beginning of 2022. Currently, you can find FDIC-insured five-year CDs with interest rates of approximately 4.5%.

Hopefully, actions by the Federal Reserve will help curb inflation. If so, returns on traditional investments such as indexed equity funds and longer-term fixed-income funds will improve. But there is no certainty that will happen.

So, for conservative investors who are concerned about preservation of capital, it is prudent to consider moving some of your money into shorter-term investments such as money-market funds, Treasury bills, Treasury notes and relatively short-term CDs. As inflation comes under control, you can consider using dollar-cost averaging from conservative investments into conservative equity mutual funds/ETFs. Fortunately, there are now conservative short-term investment alternatives that offer reasonable returns as well as capital protection.

Elliot Raphaelson welcomes your questions and comments at [email protected].