What the Rate Cut Means for Investors

Bernanke & Co.'s latest move takes the fed funds rate to 1%. With rates this low, where can investors safely get some extra yield from their savings?

After the latest move by the Federal Reserve to cut interest rates, investors may find it even harder to earn extra income off their savings.

The Fed lowered the federal funds rate to 1% on Oct. 29. Though occasionally the rate has hit that level—most recently in 2004—the fed funds rate hasn't been lower than 1% since 1958.

Market observers weren't sure how much immediate effect the Fed move would have: The yields on safe U.S. Treasury securities are already very low. Many hope interest rates eventually fall on home mortgages and consumer debt, because that would stimulate the economy. But those hopes rest more on restoring confidence to the financial system first. "If financial institutions aren't willing to lend to each other, not much is going to leak through to consumers," says Ward McCarthy of Stone & McCarthy Research Associates.

Looking for Yield in Stock Dividends

The rock-bottom federal funds rate is a sign of the times in credit markets: As investors have piled into Treasuries and other relatively safe hiding places, it is harder to get a decent payoff for your money.

One option, of course, is the stock market, where many equities pay out a quarterly dividend. General Electric (GE), for example, pays out a 7% dividend yield, while Bank of America (BAC) pays a 6.2% yield.

Yet these high yields also reflect serious worries about these companies' prospects. GE or BofA shares have tumbled all year. If that continues, equity investors could lose more from the falling stock price than they earn from their quarterly dividends.

Reaching for Yield

The credit markets are usually preferred by conservative investors trying to protect themselves from risk while still generating income. But here, too, the risks are everywhere.

Corporations issue bonds, but the higher the interest rate the bond pays to its holders, the riskier it tends to be. "The yield is where the risk is," says Marilyn Cohen, chief executive of Envision Capital Management. "One of the reasons the economy got in trouble is people were really reaching for yield in the last few years," says Steven Medland, a partner at TABR Capital Management in Orange, Calif. "They were getting paid very little to take that extra risk."

High-risk bonds are paying higher yields these days, but the risks are also so much more obvious than in the past. In corporate bonds, "There is some risk in there because some of these corporations are going under," says Marshall Groom Jr. of Groom Financial Advisory in Richmond, Va. The risk of default and bankruptcy rises depending how serious the recession gets.

International Bonds Can be Risky

Still, says McCarthy, bonds of "some pretty high-quality companies" are trading at wide spreads, meaning their yields are far above those of the safest government bonds.

International bonds can also be risky, but this is an area where it might make sense to find a bond manager you trust, Groom says. The manager can find the right balance between risk and reward. Groom recommends the T. Rowe Price International Bond Fund (TRIBX) to his clients.

A remarkable feature of the current financial crisis is that it "has affected everything," Cohen says. All parts of the credit market have been disrupted in some way, and the turmoil has barely begun to ease. "The market is still fraught with problems," she says. "There is still a terrible freeze in liquidity."

Muni Markets Rocked

The municipal bond market is typically a sleepy part of the bond universe, a haven for conservative, risk-averse investors trying to get income while protecting themselves from taxes.

Things aren't so sleepy now. The muni market has been rocked in the last couple months, says Matt Fabian of Municipal Market Advisors. Muni yields rose by 1.5 percentage points from mid-September to mid-October, which is a huge move for such a conservative market.

Since then, yields have fallen, but Fabian says there is a "great opportunity for yield, though not necessarily for performance." Bond "prices have been very volatile [and] could well continue to decline for the foreseeable future," he says. However, the risk of default on most municipal bonds—issued by states, cities, and other local governments—is very small even during a recession. As long as you avoid the small number of riskier munis, you can be reasonably sure you'll get your money back.

Tax-Protected Munis Hold Appeal

Plus, says Cohen, tax rates are likely to rise no matter who wins the Presidential election. That makes tax-protected munis more attractive.

Both Cohen and Fabian advise buying individual munis rather than muni bond funds, saying they tend to offer better yields at this time.

For the entirely risk-averse, there are better options than putting your money under a mattress. There is always super-safe government debt. One option is the iShares Lehman One-to-Three Years Treasury Bond Fund (SHY).

Don't Play It Too Safe

Another safe option may be money market funds or certificates of deposits at banks, which might provide a little income while providing nearly airtight assurance that you'll get your money back. Bank deposits are insured up to $250,000 by the Federal Deposit Insurance Corp., and the government has recently provided similar assurances to money market fund holders. (Though of course you should make sure these guarantees apply to the particular investment product you buy.)

But Medland, even as he is pursuing a conservative investing strategy right now, warns about playing things too safe. Skittish investors may want to move entirely into cash. That "feels comfortable in the short term," he says. But conditions will improve and, because of the threat of inflation, over the long term cash is a "losing proposition."

As famed investor Warren Buffett wrote this month: "Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value."

Investors Have Many Options

For investors looking for a little income, the financial crisis has made life difficult. The risks of a reckless investing style have become apparent. "Anyone who is willing to take a little risk will find some values out there," McCarthy says. "The problem is there is a justifiable reluctance to be the first person in the pool."

Ultra-low interest rates may eventually ease the crisis. In the meantime, investors have many options — along with a lot of uncertainty to accompany them.