Dante warned us that there’s a special place in the underworld for people who make puns about the financial and musical uses of the term “CD” but I like to tempt fate.

I’ve been thinking about reviving my old CD collection. No, I’m not talking about deleting iTunes. I’m talking about inviting some certificates of deposit into my retirement portfolio.

People generally think of CDs as investments for risk-averse retirees—or, at least, we did before interest rates plummeted to historic lows. And you can’t usually buy CDs inside your 401(k) or other workplace retirement plan, even if you want to.

Despite this, CDs have some peculiarities that make them worth a look, even if you’re a long way from retirement.

Certified financial planner Allan Roth (who did not invent the Roth IRA, though wouldn’t that be cool?) writes the Irrational Investor blog and is such a strong proponent of CDs that he is considering changing his name to Allan CD (not really).

Banking on CD singles

Two years ago, I wrote about using CDs for your emergency fund. That was Roth’s idea and I’m glad I took his advice. Most of my emergency fund is sitting in CDs paying 2.74%, with a tiny 2-month early withdrawal penalty. That may not seems like a high interest rate, but compared to an online savings account paying less than 1%, it’s delightful.

Roth says there’s no reason to stop there; I should also consider using CDs as a replacement for bonds in my retirement savings. “I have roughly 70% of my fixed-income portfolio in CDs,” he says.

Why? Because CDs offer two features bonds don’t:

Higher interest. Right now you can buy a 5-year US treasury bond paying 0.92%. An equally safe FDIC-insured 5-year CD from Ally Bank pays 1.79%. A 7-year CD from PenFed Credit Union pays 2.75%, while the comparable treasury bond pays 1.49%. Why would anyone buy the treasury bond?

Less interest rate risk. When interest rates go up (and wouldn’t that be nice?) bond prices go down. That’s not true of CDs, which don’t fluctuate in value. If rates go up, you can just break the CD, pay the penalty, and buy a new CD—or a bond, if bond rates are superior in the future. Of course, if interest rates go down, CDs don’t go up in value, either.

We could also compare CDs to a broad-market bond index fund like the AGG ETF, which has a yield of 2.04% and a duration of 4.3 years. That’s not terribly different from the rate on the Ally Bank CD, and it introduces default risk: about a third of the bonds in the index fund are corporate bonds, which are riskier than US government bonds.

“So I’m getting almost the same yield, I have less default risk, and far less interest-rate risk,” says Roth. Why should this situation persist? “There’s this inefficiency we can take advantage of that Goldman Sachs can’t,” he says. CDs are only risk-free up to the federal insurance limit of $250,000 (double that for a joint account; even more if you open CDs at multiple institutions). I consider that a lot of money. A giant investment bank doesn’t. A bank that needs to bring in deposits has to offer a higher CD rate, but doesn’t have to convince us that the bank is secure, because deposits are insured.

Smooth or chunky?

I have no argument with any of this, and yet I haven’t put any of my retirement portfolio into CDs for several reasons, some more legitimate than others. Listen in while I try to talk myself into it.

Bond funds are smooth; CDs are chunky. Every month, I make a contribution to my retirement account. Setting up an automatic contribution to a bond fund is a snap. No bank that I know of allows you to automatically buy CDs every month, so I’d have to do it manually. I hate manual transactions. Furthermore, it’s almost time to rebalance my investments. This will involve selling bonds and buying stocks. With a bond fund, that’s two clicks of the mouse. With a collection of CDs, it means either redirecting a few months of future contributions to stocks (and remembering to set it back later) or calling the bank to break some CDs. Which brings us to…

Breaking CDs feels wrong. “There is the psychological aspect of a penalty, which you need to get over,” says Roth. “I have the right to sell my CDs back to Ally Bank.” If interest rates rise and people start breaking their CDs all over the place, that might turn out to be the end of the small early withdrawal penalty, but that’s no reason you and I can’t break CDs today.

My bond funds did great last year. In 2011, I got double-digit returns on bonds. If I’d bought CDs instead, I would have made maybe 2.5%. This is an absolutely terrible reason to favor bond funds, however, because it’s looking only at the first year of a five-year investment. What goes up will probably come down.

There are no inflation-protected CDs. I prefer inflation-protected US treasury bonds (TIPS). In the world of CDs, there’s no such animal. Roth says it’s unnecessary: with high inflation comes high interest rates, and again, you can just break your CDs and buy higher-yielding ones. There’s your inflation protection.

The verdict

Well, I’m convinced: by adding CDs to my retirement portfolio, I can get a higher return and take less risk. But I’m still sticking with bond funds.

Why? For simplicity’s sake. My wife and I have all of our individual retirement assets at a single mutual fund company. Buying CDs would mean opening IRAs at a bank and moving money between the fund company and the bank. Smells like paperwork. Then we’d find ourselves tending a herd of CDs, making manual transactions and having to figure out when to call the bank to break them.

This is just too much of an affront to my preference for keeping investing simple (my wife and I own a total of four mutual funds) and automating wherever possible. As Mike Piper, of Oblivious Investor, put it recently, “As to embracing simplicity for simplicity’s sake, you bet I do.” Me too!

If you’re a more hands-on investor, however, and want to add some CDs to your portfolio, you can buy them for your traditional or Roth IRA at most banks and credit unions. You can compare CD rates and terms on Mint.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.

Hey, want to sock away some money and earn 3.83% interest over the next 12 months? That’s better than the rate on online savings accounts (about 1%) and 1-year CDs (1.2% at best). It’s even better than the rate on 5-year CDs.

Furthermore, unlike savings accounts and CDs, the financial instrument I’m talking about is guaranteed to keep up with inflation, and you can hold it for up to 30 years. You’ll never pay state or local income tax on it, and don’t have to pay federal tax until you cash it in.

This is real, risk-free, and not a scam; there are almost no catches. You can and should do it today, because that guaranteed 3.83% rate expires at the end of October.

I Bonds Revisited

I’m talking about Series I US Savings Bonds–“I-bonds” for short. (No, they’re not an Apple product.) At a time when complaining about low interest rates is our national pastime, few people know about these bonds. The Treasury has no budget for advertising savings bonds, so you have to hear about them from fans like me. They’re the financial equivalent of an unsigned indie rock band, except that savings bonds have been around forever and will never be featured in Pitchfork.

“It’s a product designed for Main Street, not Wall Street and the banking industry,” writes Chris Farrell in Kiplinger’s. That’s exactly it: only individuals can buy savings bonds. If I-bonds were a club, Goldman Sachs wouldn’t make it past the velvet rope.

Buying savings bonds has a reputation for being complicated, so I’m going to tell you exactly how and why to do it. I’m buying some today; you should, too.

How They Work

I-bonds are like certificates of deposit. You put money in, it grows in value, and at some point you cash it out and spend the money.

You can’t cash out an I-bond until its first birthday, so don’t put in any money you might need in the next year. If you cash it out in less than five years, you pay a small penalty: you give up the most recent three months of interest payments.

Unlike a CD, an I-bond has a variable interest rate tied to the rate of inflation. If you buy an I-bond before October 31, it will pay 4.6% APY for six months and then 3.06% APY for the following six months (3.83% is the average of the two rates). After that, the interest rate will change again: it changes every six months and could go higher or lower, but it will never be less than the inflation rate.

To put it simply: if you buy a $1,000 I-bond (which has a picture of Einstein on it) today, it will be worth $1038.30 in a year. Again, that’s by far the best you can do in a risk-free investment today.

Each person can buy up to $10,000 worth of I-bonds this year. The limit drops to $5000 starting in 2012.

How to Buy

The easiest way to buy I-bonds is to mail-order them, Sears Roebuck style. (Yes, my jokes are as venerable as savings bonds themselves.)

Just fill out this form, print it, and mail it with a check. This will probably be the only time in your life you write a check to the Federal Reserve Bank of Minneapolis. They’ll mail you the bonds in a couple of weeks. As long as your check arrives by October 31, you’ll get the current, delicious interest rates.

If you can only afford to put $5000 or less ($10,000 for a couple) in I-bonds right now, stop reading, submit your order, and relax with a beverage knowing you’ve joined a secret society of expert savers.

Because here’s where it gets complicated. You can buy up to $5000 in paper bonds (that’s what you’ll get via mail order) and another $5000 in electronic bonds. To buy electronic bonds you have to sign up for an account with TreasuryDirect, the government’s direct bond sales web site. It’s similar to signing up for online banking, but the security measures are Iron Curtain-inspired.

Starting next year, you won’t be able to buy paper bonds any more, so if you want to keep buying I-bonds, you’ll have to sign up for TreasuryDirect, in any case.

The Take-Home

I-bonds are the perfect savings tool for short- to medium-term savings goals: down payment, vacation, college tuition (if you use I-bonds to pay for college, you can cash them in tax-free). The fact that you can’t cash them in for a year protects you from impulse buys. They grow tax-deferred. They never lose purchasing power due to inflation.

Nobody regrets buying I-bonds. If you have money sitting around earning 1% or less, pick some up today.

Welcome to the club. Let’s work on a secret handshake.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.

If interest rates rise sharply—something bound to happen in the future, since they can’t go any lower than they are now…

Good news, right? Unfortunately, I made this prediction in February 2010, and I was completely wrong.

But I’m just some guy. What if we asked professional economic forecasters, people whose job it is to, y’know, make economic forecasts?

Well, two years ago, in July 2009, the Wall Street Journal asked fifty forecasters whether the interest rate on the benchmark 10-year treasury note would be higher or lower a year later, in July 2010.

If you were to sum up the forecasters’ sentiment at the time, it would be, “Interest rates can’t go any lower than they are now.” Forty-three of them predicted higher rates. Five predicted slightly lower or static rates. Two out of fifty predicted much lower rates.

You already know how that turned out: rates went much lower, from about 3.5% to 2.95%.

Surely, forecasters got smarter after that, though, right? Bill Gross is generally considered the world’s greatest bond trader, and he’s in charge of the world’s biggest bond fund, PIMCO Total Return (PTTRX). In February, Gross sold all of his fund’s treasury bonds, warning that interest rates couldn’t go much lower. The 10-year T-note was once again yielding about 3.5%. In June, with yields at about 3%, he stepped up the rhetoric, warning that treasury investors would “get cooked like frogs in an increasingly hot pot of water.”

So how did that work out? Two weeks ago, the Wall Street Journal reported:

“In recent weeks, Pacific Investment Management Co. founder Bill Gross says he has ‘lost sleep’ over an ill-timed bet on Treasurys.”

The current 10-year rate: 1.98%.

This is starting to sound like a slapstick comedy - like Caddyshack with interest rates instead of the gopher. Let’s check in with the WSJ’s favorite economic forecasters: According to the August 2011 survey, the consensus is that 10-year rates will climb to 3.5% by December 2012.

Here is the take home message for you…

Don’t bet on it

No matter what anyone says, interest rates can still go much lower. That doesn’t mean they will. Nobody can predict interest rates. Not economists, not bond fund wizards, and certainly not you and me. If you’re doing anything with your money based on an assumption about future interest rates—such as shifting your bond portfolio to cash while waiting for bonds to return to “normal” rates—you’re gambling, plain and simple (the same goes for waiting for the stock market to return to normal, but that’s another story.)

Mike Piper of the Oblivious Investor blog made that mistake: he shifted to short-term bonds, figuring interest rates had to rise. But he was big enough to admit it, eloquently:

It’s easy to make observations about current market conditions (e.g., ‘by historical standards, interest rates are unusually high/low’ or ‘by historical standards, stocks are expensive/cheap’). But interest rates can stay low (or high) and stocks can stay cheap (or expensive) for a very long time. And unless we can predict when things will change, it’s difficult to draw much benefit from such observations.

You know what I want? I want to buy a long-term inflation-protected bond paying a real rate of 3.5%. I also want a pony with a silver saddle. I hate low interest rates as much as the next guy, but there’s almost nothing I can do about it.

I say “almost” because there are a couple of ways to beat zero interest, modestly:

Save more. Sorry. Had to say it.

Consider certificates of deposit. According to DepositAccounts.com, the best 5-year CD pays 2.73% interest. A 5-year treasury bond pays 0.88%. They’re equally safe. This is like choosing between the same iPod selling for $100 or $300. Take your pick. Most banks let you hold CDs in an IRA.

Don’t forget savings bonds. Series I savings bonds, which track inflation, are currently paying 4.6% for the next six months, and an undetermined rate after that. You can cash them in anytime after the first year. You can buy up to $10,000 in I bonds this year ($5000 electronic and $5000 paper); that’s expected to drop to $5000 next year when paper bonds are discontinued.

And remember the most important lesson of all: When interest rates are low, it’s easy to get talked into something with a little more yield and, supposedly, no more risk. But anything that pays more than a CD or I bond is probably risky. If it doesn’t look risky, that’s even worse: it’s risky in a way that will kick you like an angry pony when you least expect it. Remember Schwab’s YieldPlus fund (SWYSX)? It was like a money market fund, only with a higher interest rate.

That’s an actual chart in the link. It also looks like what happens to my brain when I try to predict interest rates.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.

Ever notice how nobody ever says “bonds and stocks”? In fact, ever heard anyone bring up bonds at a party and seen his listeners stick around? The more animated conversations always tend to revolve around stocks. Today, we’re putting the supposedly safe-and-boring part of your portfolio in the spotlight. The bond market is way bigger than the stock market and it’s time to get schooled, Bonds 101 style. In this infographic, we’ll
walk you through how owning bonds makes you a little like a bank; the different kinds of bonds you’ll meet in your financial neighborhood; how to tell safe bonds from junk bonds; and why savvy Susie isn’t “interested” in buying Bob’s $1,000 bond for $1,000. Ah, bond humor!

photo: allyrose18

Want to hear about a great investment? It’s totally safe and tax-advantaged, it pays 0% interest, and…hey, come back here!

The investment I’m talking about comes from the US Treasury, and it’s called a Series I Savings Bond, or just an I Bond for short. It’s one of two types of US savings bonds currently sold (the other is series EE bonds). I Bonds really are great, in their own peculiar way, and here’s why you might want to own some, despite that 0% interest rate.

The real deal

The “I” in I Bonds stands for “inflation,” and an I Bond is guaranteed to keep up with inflation as measured by the Consumer Price Index (the CPI-U, for us nerds).

A 0% I Bond, therefore, will rise in value over time, as long as we have a positive rate of inflation, thanks to its inflation adjustment rate. Right now, that rate is 0.74%. The Treasury resets it twice a year to equal the rate of inflation. “Your return is going to be based entirely on inflation adjustments, and that is true for the entire life of the bond,” says Annette Thau, author of The Bond Book. (I Bonds are also safe from deflation, because the principal can never go down.)

That makes I Bonds basically the world’s safest, most boring investment. It’s like a government-insured mattress. Plenty of people are looking for exactly this sort of investment. You’ll never get rich off I Bonds, but you’ll never lose money, either. I Bonds don’t always pay 0%, either: the real rate on new I Bonds, just like the inflation adjustment rate, changes twice a year and will be adjusted next in May. (Changes in the real rate only affect new bonds, not any existing bonds you already own.)

But because Americans are still freaked out about the economy and worried about inflation, the government doesn’t have to pay any interest to convince people to buy I Bonds. In the past, the real interest rate on I Bonds has gone as high as 3.4%. Once you have an I Bond, you can cash it in after one year or sit on it for up to 30 years.

This ignores, of course, the debate over whether the government’s inflation numbers can be trusted. I think they can, and I’m going to explain why in a future column, but for now, let’s just agree that I Bonds are just as good at keeping up with inflation as any cost-of-living adjustments you might already be familiar with.

Furthermore, I Bonds are tax-deferred. If you have an I Bond sitting and increasing in value, you’re not taxed on it until you cash in the bond. And if you use the proceeds of the I Bond to pay for college, you’re not taxed at all.

Shopping at Uncle Sam’s bond emporium

On the eat-my-own-dogfood principle, I bought a $50 I Bond last week by shopping at the government’s TreasuryDirect web site. I will say two things about TreasuryDirect:

1. Once you’ve established an account and signed in, it’s a well-designed web site that lets you easily shop for savings and treasury bonds with no fees or markups and keep them in an online account where you can check up on them anytime. Hooray for government that works.

2. Establishing an account at TreasuryDirect and signing in requires following a security protocol that, as far as I can tell, was designed jointly by the TSA, the North Korean office of emigration, and some retired Berlin Wall architects. Just to log in, you have to type your (long and unpronounceable) password by clicking keys on an on-screen keyboard with your mouse. Then you have to look up some characters on a plastic security card which you receive by snail mail when you sign up. Then your webcam clicks on and you have to…okay, now I’m pulling your leg.

You can also order paper I-bonds from any bank, and they’ll be mailed to you. (The $50 I Bond features a picture of Helen Keller, who was also involved in designing the TreasuryDirect.com security protocol.) But it’s worth braving the barbed wire of TreasuryDirect, because keeping track of a piece of paper for years is even harder than using your mouse to type “ZC$&#Ggfe^.” Oops, now I have to change my password.

The downsides

A few caveats about I Bonds:

* They can’t be held in a retirement account. “401(k) and IRA should be maxed out before considering I Bonds” for retirement, says The Finance Buff, a pseudonymous blogger and author of Explore TIPS.

* There are purchase limits. An individual can buy up to $5000 in electronic I Bonds plus $5000 in paper I Bonds per year. (You can then go onto TreasuryDirect and convert your paper bonds to electronic. Attention comedians: have you considered doing a routine about how sometimes the government makes things more complicated than necessary? I smell laughs.) If you feel constrained by these purchase limits, I envy you.

* I Bonds are nontransferable. You can’t sell or give them to someone else once your name is on them. (You can buy them for other people as gifts, of course. The kids will say, “What the hell is this?” but they’ll thank you later. Maybe.)

* If you cash in an I Bond in less than five years, you’ll pay a small penalty (3 months interest, including interest due to inflation adjustments).

* The security goons at TreasuryDirect may or may not save your backscatter X-ray picture. Just kidding! Of course they’ll save it.

Again, I Bonds are not a “great investment” in the sense of “potentially lucrative.” You wouldn’t run and put all your money into I Bonds even if you were allowed to. They’re absurdly safe, dull, and easy to understand: they work like a CD, but you can’t lose money, even due to inflation, and can sit on it for up to 30 years.

Just don’t lose your TreasuryDirect password. You don’t even want to know what’s involved in getting a new one.

(iStockphoto)

Look, I know this isn’t the sort of thing you should say on a date, but just between you and me: I keep an eye on the bond market, and there’s something interesting going on. Maybe not as interesting as celebrity gossip (if there isn’t a rapper named T-Bill, there should be), but interesting nonetheless.

Here’s what’s happening, why you might care, and what you should do about it if you do care.

Blue light special on US debt

We’re going to be talking here about US treasury bills and bonds (for convenience, let’s just call them all “bonds”). These are not the same as savings bonds, which have purchase limits and can’t be stored in retirement accounts. (Not that there’s anything wrong with savings bonds.) A treasury bond is just a small piece of the national debt: you’re loaning Uncle Sam some cash for a set period of time—anywhere from one month to 30 years—at a particular interest rate.

When people talk about treasurys (and yes, it’s usually spelled that way), they often refer to the price or the yield, which are really used to make the same point. If someone says a bond has a low price, that means it has a high yield (pays lots of interest), and vice versa.

What’s been happening in the bond market (and soon, you too are going to be saying “bond market” and getting kicked out of parties) is that yields have been going up. Or prices are coming down.

This is the opposite of what’s been happening since fall of 2008. Everyone from the Federal Reserve to grandma’s pension fund has been buying super-safe treasury bonds, driving prices up (and yields down), just like when the Wii was going for $500.

The US Treasury reports bond yields every day on its Daily Treasury Yield Curve page. As of December 13, 2010, the 10-year T-Bill is paying 3.28%. If you’re in the market for some, that’s a big improvement from a month ago, when it was paying 2.65%.

Why to buy

There’s no magic number that tells you when treasury bonds are cheap or expensive. You have to look at your own financial plan and figure out how treasurys fit in.

That’s what I did this week. I have a retirement spreadsheet that tells me that to hit our retirement goals with our current saving level, my wife and I need to earn at least 1.8% on our savings after inflation.

Fortunately, the US offers a type of a bond that adjusts automatically for inflation: Treasury Inflation-Protected Securities (TIPS). The 30-year TIPS is paying 1.95 (a month ago: 1.58%). That sounds good to me, so I’m going to take a small portion of my retirement savings and buy an individual 30-year TIPS. This comes with some risk (if I need the money early, I might have to sell the bond at a loss, and I might not be able to reinvest the dividends at the same 1.95%), but it lets us lock in a rate consistent with our goals—and that lets us reduce our exposure to riskier assets.

Long-term nominal (non-TIPS) bonds are not really appropriate for individual investors: a spell of unexpected inflation could eat up the value of your bond like a freelance writer let loose at an all-you-can-eat buffet. (Trust me, neither scenario is pretty.)

How to buy

There are three ways to buy treasurys.

1. In a mutual fund or ETF. This is the right way to go most of the time: it’s easy to reinvest dividends, and the return is comparable to buying individual bonds. Vanguard, for example, offers low-cost funds that own short-term treasurys (VFISX), intermediate-term treasurys (VFITX), long-term treasurys (VUSTX), and intermediate-term TIPS ((VIPSX), which I own). If you’re looking at short-term treasurys, however, consider just buying a CD instead: they pay higher rates at the moment and are equally safe.

2. Individual bonds in a taxable account. You can buy bonds directly from the government with no fees at TreasuryDirect.gov

3. Individual bonds in a retirement account. If you want to put individual bonds in an IRA, you have to buy through a broker. Of the major discount brokerages, Fidelity and Schwab allow you to buy treasurys online with no fee or markup. (Note: I’m a Schwab customer.)

As rapper T-Bill put it on his classic mixtape Yield Curve, well, none of that imaginary record is quotable in this family-friendly publication. But I think he would, in his own unprintable way, encourage you to keep an eye on the bond market.

(photo: iStockphoto) 

When is it time to dump an investment?

My friend Robert (not his real name) is retired. Since he’s a risk-averse investor, I was surprised when I got an email from him last week with some bad news.

Back in 2007, when he was still employed and the economy was still awesome, Robert called his broker. “I was looking for extremely safe, conservative investments with good rates,” said Robert. “And he said, here are some extremely safe, conservative investments with good rates.”

The investments were with Lehman Brothers, GMAC, and Royal Bank of Scotland (RBS).

Lehman went bankrupt, GMAC was bailed out three times, and RBS was taken over by the government of the UK.

But it’s not as bad as it sounds: the Lehman investment was an FDIC-insured CD. The GMAC bond is still paying 5.85%.

But RBS? Big trouble. Robert bought $35,000 worth of RBS preferred stock paying a 7.25% dividend. RBS is the world’s second-largest bank and was founded in 1727. What could go wrong? Preferred stock sounds great. And 7.25%? Wow! To use an arcane financial term, that is one bitchin’ yield.

Robert and his broker were far from the only people who thought this RBS stock looked like a great deal. One blogger argued in 2009:

“I don’t believe that Royal Bank of Scotland would ever stop paying its preferred dividends because to do so would tarnish the name of that company forever—royalty sits on their board of directors and the company was incorporated before George Washington was born.”

Well, guess what? Preferred stock is risky. As Larry Swedroe put it in this book The Only Guide to Alternative Investments You’ll Ever Need: “Investors should be aware that in times of financial distress, the payment of preferred dividends could be deferred.”

You don’t say. As of April, Robert’s RBS preferred stock stopped paying dividends by order of the Queen. (Actually, it was the European Commission, but “by order of the Queen” has such a ring to it.) A chunk of Robert’s income went up in smoke.

Furthermore, the stock’s market value has collapsed, too—it’s currently down 31% from what Robert paid for it (although that’s an improvement from when it was down 50%).

Now Robert’s in a quandary. The Financial Times says RBS is expected to resume paying dividends in fall of 2010. Should Robert hold onto his investment in hopes that the dividends will come back and so will the price of the stock?

Stretching for yield

Robert got into trouble the moment he asked his broker for high yields. Higher yield and higher risk go hand-in-hand, and many people buy corporate bonds, preferred stock, dividend stocks, and brokered CDs without understanding that these instruments pay higher dividends because they are risky. Let’s take a quick look at each:

Corporate bonds: Buying an individual corporate bond, no matter how highly rated, still exposes you to the risk that the company will go bankrupt and default on its debt. You could lose everything.

Preferred stock: “A lot more is wrong with preferreds than right,” writes Jane Bryant Quinn in Making the Most of Your Money Now. Preferred stock offers less growth potential than common stock and more risk than bonds.

Common, dividend-paying stock: That’s even riskier than preferred stock: both bondholders and preferred stockholders get first dibs on dividends. Common stockholders are way down the list. As with preferred stock, you’re likely to lose your dividends and your principal at the same time, because when a company stops paying dividends, the stock usually collapses. I often see people advising retirees to buy AT&T (T) stock for the dividend income, as if nothing could possibly go wrong with AT&T.

Brokered CDs: Brokered CDs are generally FDIC-insured (although you should always check). There’s no chance of losing principal if you hold them to maturity, which makes them the safest of this cagey bunch. But they’re less safe than bank CDs for two reasons. First, brokered CDs are callable. That means that the issuer can, on a whim, give you back your principal and yank back its CD. This is likely going to happen at a time when you have to reinvest the money at a much lower interest rate, and that means the high rate on a brokered CD is essentially fictional. Second, say you want to get out of a brokered CD: you can’t just pay a small penalty and be on your way, as with a bank CD. You have to sell the CD—possibly at a loss.

I’m not saying no one should ever buy any of these things. But Robert bought them without realizing he was taking any risk at all.

“I was ignorant,” said Robert. “I listened to this broker, and you know what? He was ignorant, too. If there hadn’t been a financial crisis, there’d be no problem.”

Hold or sell?

I asked Robert whether he was going to sell his RBS stock. “I haven’t made a firm decision,” he said. “It’s very difficult to sell. I’m down $11,000. I look at this money I’d be losing, and it’s like a year of earning on my portfolio. It’s so much money.”

“Then you must think the stock is underpriced and it’s going to start paying dividends again,” I said. “Does that mean you’re going to buy more of it?”

“I’m not going to buy more of it! It’s obviously risky.”

“Then let me ask you this,” I said, reaching for the heavy artillery. “Let’s say I took away your RBS stock and gave you the market value in cash. Would you buy it back from me?”

Pause. “I have to think about that.”

He called me back about ten minutes later. He’d decided to sell the RBS and buy a 7-year credit union CD paying 3.49%. It’s insured, non-callable, and (because it’s in an IRA) has no withdrawal penalty. In other words, it’s safe. Just what he was looking for in the first place.

(photo: iStockphoto)

It’s time for another episode of everyone’s favorite investing game show, Where Should I Put My Cash?

First, a review of the ground rules. Money market mutual funds are currently yielding 0.04%, according to iMoneyNet.com. The average savings account, according to Bankrate, yields 0.69%. The best online savings accounts? About 1.3%. All of these rates sound suspiciously close to what a mattress pays (although that’s deceptive, since inflation is close to zero as well).

In past installments of the show, I’ve looked at:

• Reward checking accounts
• Long-term CDs
• Betterment.com, a streamlined stock/bond portfolio

Today, let’s look at bond funds. Should you keep your cash in one?

The short answer: probably not. The long answer: well, it’s a pretty long answer.

An avalanche of cash

Believe me, we’re not the only ones looking at bond funds. According to the Investment Company Institute, investors sunk an astonishing $185.6 billion into bond funds between January and the end of July. Where did all that money come from? Not from stocks: over the same period, investors pulled “only” $1.68 billion out of stock funds.

Instead, it came from money market funds. Surprise, surprise: investors were tired of earning 0.0%. But a bond fund is not the same thing as a money market fund, and it’s worth investigating what you can expect from a bond fund and how to stay safe.

Bond funds come in many flavors, because bonds come in many flavors. (Dibs on chocolate.) You can buy a treasury bond fund in your choice of short-term, medium-term, long-term, or inflation-protected. You can buy a corporate or mortgage-backed bond fund, a fund full of junk bonds or tax-free municipal bonds.

This is starting to sound like a showtune, and jaunty musical numbers are not my style, so let’s focus. If you’re looking for a safe place for cash, treasury bonds are going to be what comes to mind—and not just your mind, since a lust for safety has driven treasury bond yields to historic lows.

For the bond fund investor looking for more yield, that’s a problem. If you want more return, “You can go down in credit quality, or you can go out in maturity,” says Carl Richards, who writes about personal finance (and does cool napkin sketches) for the Bucks blog at New York Times. “You can replace ‘yield’ with ‘risk. So if you say ‘high-yield fund,’ you mean ‘high-risk fund.’”

Risky biscuits

Yes, that means a bond fund full of nothing but “totally safe” treasury bonds has risk. The main risk is rising interest rates. When interest rates go up, bond values go down, and vice versa. (Richards has a napkin illustrating this principle.) Your bond fund has a single number (available by looking up the ticker symbol on, say, Google Finance) that tells you how sensitive it is to interest rates: the average duration.

Chris Philips, a bond analyst at Vanguard, says this simple relationship between interest rates and duration overstates the risk of bond funds. “Rising interest rates don’t have to mean negative returns for an investor in bonds,” he says. He points to the post-dot-com bubble days in the early 2000s. The Federal Reserve raised interest rates several points over a period of several years. However, “it was a very systematic, very well-communicated increase in interest rates,” and Vanguard’s short- and intermediate-term treasury funds did fine. The higher interest payments per share more than compensated for the loss in share price.

Richards is unconvinced. “You have no idea whether the Federal Reserve is going to give signals or how rates are going to go up. The only thing we know is that we don’t know.” He’s not saying bond funds are as risky as stock funds, but he considers them an inappropriate vehicle for cash. “Just buy high-quality short-term bond funds. Their only purpose is to allow you to sleep at night while your stocks grow.”

I asked Richards where he keeps his cash. “In the backyard,” he laughed. Actually, he uses an online money market deposit account. But let’s all go dig up his backyard, just in case.

Cash-only lane

Low interest rates drive investors a little mad. We divide our money into two buckets—the cash and the portfolio—and then we get jittery if the cash doesn’t seem to be bringing us regular gifts in the form of sweet, buttery interest payments.

We forget—and as the guy who put most of his emergency fund into a CD two weeks ago, I’m as guilty as anyone—that the whole point of cash is that we can lean on it in hard times, like the shoulder of an old friend. If your friend says, “Sorry, I can’t come over, I’m washing my hair,” that is one thing. When Benjamin Franklin says it, it’s even worse.

In other words, it’s okay for your cash to lie around like a cat on the sofa arm. Sure, go for that 1.25% online savings account or low-penalty CD instead of the 0% money market fund. But your cash should hang in there in both rising and falling interest-rate environments.

Bond funds are a vital part of an investment portfolio. As a parking spot for cash, however, they’re not worth the risk. As Richards put it, “People think that this is a money-market replacement, and they’re going to get whacked.”

Editor’s Note: Few things can kill a cocktail conversation like bond talk — and we are obviously not talking about the kind of bond preceded by “James.” Not only do most people think bonds are boring, they also find them incredibly confusing. If you want to be a smart investor, though, you should know where your money is going — and that includes understanding bonds and their most complex feature, pricing.

This week, MintLife presents the third article in our Investing 101 series, provided by Minyanville.com.

A bond is referred to as a debt instrument. The corporation or government issuing the bond promises to repay the full value of the bond, or par value, with interest and by a specific due date.

A 3% bond with a par value of $1,000 is a contract between the issuer and the bondholder, where the issuer pays annual interest of $30, or 3% of the par value. On maturity date, the par value of $1,000 is repaid.

Because bond interest rates are fixed, but market rates are constantly changing, bond values also change all the time. When interest rates are higher than that offered by a bond, that bond becomes less desirable. As a result, that bond will be worth less than its par value and sell at a discount.

If market rates fall below the bond’s fixed rate, the bond becomes more attractive and it starts selling at a premium.

For example, when a bond is at 102, it is worth $1,020, or 2% above par value. If a bond is at 97, it has been discounted to 3% below par value.

The changes also affect the yield on the bond.

No matter what its current market value, the bond always pays the same interest. A 3%, a $1,000 bond pays $30 per year:

            Interest rate x par value – Interest              (3% x $1,000 = $30)

This so-called nominal yield is also calculated by dividing the interest paid per year by par value:

            Interest ÷ Par Value = Interest rate              ($30 ÷ $1,000 = 3%)

If a bond is selling at a premium or discount, however, the current yield on that bond is going to be different.

For example, when that $1,000 par value is worth 102, or $1,020, the current yield is reduced:

            $30 ÷  $1,020 = 2.9%

This is only a slight difference; but for institutional investors relying on bond yields for millions of dollars, it adds up to a lot of money.

If the bond is selling at a discount, on the other hand, the current interest rate is higher. For example, if a bond with par value of $1,000 is at 97, the calculation for current yield is:

            $30 ÷  $970 = 3.1%

No matter how much a bond’s current value changes, at maturity the par value ($1,000 in these examples) is always paid. If you purchase individual bonds with the idea to hold them to maturity, in other words, you could only take into consideration the bond’s nominal yield.

But things get more complicated if you purchase bonds on the secondary market, at a premium or a discount.  In those cases, a more complex calculation of yield to maturity comes into play, including a combination of interest plus the net discount or minus the net premium. The adjustment is spread over the time remaining to maturity. So an investor buying a bond at premium or discount has to be concerned with three different versions of yield: Current yield, nominal yield, and yield to maturity.

Because debt investments are complex and contain a range of risks, most new investors will opt for money market or income mutual funds. In that way, they rely on professional management to pick bonds and other debts to include in a diversified portfolio.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes fulltime.

Investing 101: How Bonds Are Priced was provided by Minyanville.com. 

(xaf)  

Thus far, our analysis of the European sovereign debt crisis has focused on the underlying causes and the countries involved. It is now clear that Greece, Portugal, Spain and Ireland all issued too much bond debt. It is also clear that the bond market has reacted by downgrading the creditworthiness of each country.

Far more important than assigning blame, though, is forecasting what will happen next. Today, we’ll explore some potential consequences of Europe’s debt meltdown for the world at large.

Less Economic Growth

On May 17, McClatchy predicted that Europe was about to experience a severe credit crunch. If that occurs, the first casualty will be economic growth. Short-term interest rates are on the rise, which, in turn, raises the costs of borrowing money for consumers and businesses alike. Banks, too, are now finding it more expensive to borrow and lend amongst themselves. Because modern markets require credit to thrive, a credit crunch effectively acts as a brake on economic growth. Moody’s Investors Services predicts “accelerated — and painful — simultaneous fiscal tightening across Europe.”

Nor does any quick solution appear to be at hand.  

As Wrightson ICAP economist Lou Crandall told McClatchy, the higher interest rates exist due to a lack of trust in the financial system. “One of the problems,” Crandall explains, is that “the market’s immune system has been weakened because people are reminded of what can happen.” Unfortunately, Europe would not be the only victim of diminished economic growth. Because of globalization, credit crunches and stagnant growth in a handful of countries can adversely affect their trading partners as well. The inter-connectedness of the world economy makes “Greece’s problem” the world’s problem. 

Political Unrest

(PIAZZA del POPOLO)  

Before accepting a $142 billion bailout package from the IMF and European Union, Greece was compelled to adopt tough austerity measures. Government pay freezes, pension cuts and a higher retirement age were all put on the table by Greek leaders, and citizens were none too happy about it. We have already seen volcanic political protests erupt in response to these proposals. The Christian-Science Monitor reported on May 6 that violent, anarchist protesters had stormed the streets in Athens, killing three local bank employees and firebombing the area. The protests triggered a panic on Wall Street, including an 8% plunge on the Dow Jones before an eventual recovery.

NakedCapitalism.com recalls that protests of the crisis had occurred as early as February of this year in Greece, Portugal and Spain.  

It is worth recalling financial crises have helped install the worst among men into political power. Adolf Hitler, for instance, rode a wave of unrest over Germany’s massive unemployment into the Chancellor’s seat. Joseph Stalin also obtained public support by promising solutions to Russia’s economic woes. Though it’s unclear if another Hitler or Stalin is waiting in the wings, history shows that cunning politicians are fully capable of exploiting financial chaos to everyone’s detriment but their own.

Less Debt Spending in The Future

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Most of the focus on Europe’s debt crisis has been on the negative consequences. Yet, at least a few observers foresee potential benefits. John T. Reed, author of a forthcoming book on hyperinflation, argues that default makes a surprising amount of sense. After all, the main problem is that the world’s nations have grown too comfortable with profligate debt spending. There are too few constraints offsetting the political will to spend other people’s money. American politicians are as guilty of it as their counterparts in Greece, Spain, Portugal and Ireland. The various bailout plans under discussion do not make it harder in any concrete way to repeat these mistakes in the future.

Worldwide default, Reed states, could be the only way to break this entrenched habit. Once no country trusts another to repay gigantic debts, government bonds will cease being the political “credit cards” that they are today. While it is certainly a radical idea, it may actually be that default would lead to a better long-term outcome than attempting to plug the leaks with temporary bailouts. The drawback, of course, is that current bond holders of the countries in question would get nothing and have to simply eat the loss.

Summary

Despite the dizzying array of details, timelines and actors, Europe’s sovereign debt crisis is rather simple to grasp. The countries involved built their budgets and spending plans on a foundation of unsustainable borrowing. By doing so, they put themselves in a position where the slightest reduction in borrowing would send their economies into a tailspin. The bond markets and rating agencies, in turn, labeled their bonds a poor investment. Panic and chaos has ensued among the world’s investors, many of whom doubt they will be repaid. There is scarcely a less popular investment today than Greek, Portuguese, Spanish or Irish bonds. And to the extent the crisis goes unresolved, the entire world economy is at risk.  

For the previous installments of this series, read European Spotlight: Understanding The Crisis and European Spotlight: The Countries Involved.