With yields in the basement, savers and investors and are searching for ways to boost their investing income.
Today, the 10-year Treasury bond yield is a dismal 2.33 percent. The average return on bank savings accounts is paltry, although a quick search on GoBankingRates.com shows that the industrious saver can garner a 1.05 percent yield. A 1 percent interest rate is good in the current economic environment, yet compared with historical interest rates, it’s quite low.
Although the Federal Reserve is hinting at an interest rate hike during the next six months, even a small boost won’t make a big dent in the measly interest and dividend returns on your cash savings.
In their ongoing search for yield and higher returns, investors are becoming more aggressive and taking on more risk with junk bonds, peer-to-peer lending, high-yield exchange-traded funds and real estate investment trusts.
Investors, beware: There is a price for reaching for yield. Here are the risks associated with these asset classes.
Junk bond funds. Fixed-income investments may be classified as investment-grade or junk. Investment-grade bonds have a lower default risk and yield than non-investment-grade or junk bonds. Investors who choose to reach for yield and invest in junk bond funds need to understand the risks.
All bond funds’ values move in an opposing direction to interest rates. So, when interest rates rise, the value of the bond fund will drop. Longer-duration bond funds will drop further in price than bond funds holding shorter maturities. This relationship applies to all categories of bonds — investment-grade and junk.
Lower-rated junk bonds face a double whammy when interest rates rise; their values will fall, and they may face a greater likelihood of default. When borrowing costs rise, companies typically face higher interest charges and consequently greater expenses. Without a corresponding increase in revenue, a company may falter. With rising interest rates, high-yield bond funds will fall and may be subject to greater default risk, leading to more losses.
The bottom line: Know the risks before diving into a junk bond fund.
High-yield stocks and stock funds. According to USA Today’s Matt Krantz, stocks with high dividends fared worse this year than stocks with high valuations. Krantz reported that the stocks with the highest dividend yields fell 6.8 percent during the first half of the year.
He doesn’t explain the why’s of this news, but here’s a possible explanation: When interest rates rise, that means corporate borrowing costs also increase. Increasing costs are not a good thing for a business and will cut into their profits. Thus, with higher-yielding stocks, higher interest rates may leave less money remaining to pay out in dividends. In general, declining stock dividend payments hurt a firm’s stock price.
Peer-to-peer lending. This social lending platform allows the average Joe or Jane to lend money to those in need, kind of like a bank. The borrowers might want business capital, funds to consolidate credit card debt or money to pay for a remodel. The allure to the lender is that he or she can garner 7 to 10 percent returns on their cash.
The catch with these popular platforms, such as Lending Club and Prosper, is that they are relatively new. Their returns haven’t been tested during times of higher interest rates. Thus, you don’t know if there will be higher borrower defaults or other scenarios that may occur as interest rates go up. If defaults increase substantially, investors’ returns will drop.
If you choose to invest in these social lending platforms, understand that they are risky, and be prepared for uncertain future returns.
Real estate investment trusts. REITs are mutual funds or ETFs that pool investors’ money and invest in various types of real estate. They may own many apartment buildings, shopping malls, mortgages or a combination of real estate assets. Their draw is the high yield.
According to the Securities and Exchange Commission, REITs are required by law to pay out at least 90 percent of their taxable income to shareholders each year in dividends. For investors, REITs have been a gold mine. According to NAREIT, the National Association of Real Estate Trusts, recent average “listed U.S. REIT” returns have been quite impressive; one-year returns are 27.15 percent, three-year returns are 16.39 percent and 10-year average returns are 7.5 percent.
The real estate industry has benefited from historically low mortgage rates, which makes the cost of owning real estate lower than with higher mortgage rates. Since 2009, the economy has been expanding nicely as most of the country rebounds from the 2008-09 housing bust and mortgage meltdown.
When interest rates begin to rise, so will borrowing costs. This will negatively affect the costs of owning real estate and likely REIT yields. Don’t be surprised if the price of existing REITs also declines.
In sum, when searching for yield, realize that there’s a downside to higher-yield investments. When interest rates go up, the value of fixed investments falls. If you’re aware of the risks, you’ll be better able to navigate the rising interest rate environment.
More from U.S. News
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The Dark Side of High-Yield Investing originally appeared on usnews.com
