Monday, September 21, 2009

Shocking News About Investors Seeking Yield

Because interest rates are low, many investors are apparently switching from money market funds to bond funds. This may be a near fatal financial mistake.

The Fed is not going to keep rates at the current low level forever. Given that the system holds huge amounts of excess reserves and Bernanke would like to control the money supply by controlling the interest rate on those reserves, the Fed's hand may be forced at some point to push rates higher than they otherwise would, at such time we are likely to get the mother of all upward interest rate spikes.

Here's the problem money market investors face, as explained by WSJ:
Nearly 78% of taxable money-market funds, the traditional parking place for savings, are offering 0.1% or less in annualized yield, according to Crane Data LLC, a research firm. On a $10,000 balance, that will earn you a maximum of 83 cents -- yes, $0.83 -- in monthly interest income. All told, these funds hold $1.3 trillion that will generate a return of just about zilch for the people who worked so hard to save it.
Here, again via WSJ, is what investors are doing:
At Vanguard Group, more than $51 billion has cascaded into bond funds this year. "It's been like Niagara Falls," said Vanguard's head of fixed-income investing, Robert Auwaerter. Industrywide, investors sank over $40 billion into bond funds in August, an all-time high for a single month, and are on pace to break that record again in September.
Record low interest rates, and record high deficits for as far as the eye can see, do not make an attractive time to lock in long-term rates. In fact, in may very well lead to financial disaster. Locked in rates now will prevent flexibility down the road when the Fed may begin to start aggressively printing money, which could lead to severe price inflation. What's a conservative investor to do? WSJ may have the best advice:
...if you can't stand the pain of a money-market fund that offers no gain, your best bet is a short-term fund that has significant holdings of corporate bonds. A sensible choice: Vanguard Short-Term Investment-Grade Fund, which yields 2.8% and has a duration of 1.9. Whatever you do, do not chase yield.

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