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There Is More Than Stocks
Stocks are all the rage, and rightfully so. After all, who wants to earn less than inflation in today’s markets? However, while stocks get most of the love, they come with inherently more risk and volatility. Thus, safer assets must be considered for those closer to retirement or with a weaker stomach susceptible to portfolio downturn nausea. Even if it means lower returns. But remember, safety means a lower investment return!
Enter Debt & Insurance Products
Stocks represent fractional ownership in a company, meaning that stock has no guaranteed repayment of your principal. Instead, you rely on someone to pay more in the future or for dividends to provide income. However, neither are certain.
Thus, it is natural to desire an asset with a guarantee. Enter bonds, certificates of deposit, money markets, and annuities.
With bonds, certificates of deposit, and money markets, all three represent an I-Owe-You debt contract, while annuities are insurance agreements.
As a note, most of these products yield less than 4% annually in today’s economic environment, with money markets offering near 0% returns. However, they are substantially less risky than stocks.
Debt Products (Ranked By Yield)
Bonds (Medium Yield)
In Not Your Grandmas Guide to Stocks & Bonds post, I discussed how bonds come in two primary flavors: government and corporate.
The reasons vary as to why governments or companies would want to borrow money. However, borrowing usually funds a project or expense that the issuer cannot pay for until the future without issuing an I-Owe-You note.
Bonds are issued when participants agree on how much will be borrowed and at what cost. The money is then lent out and not repaid until an agreed-upon date in the future. Until then, the borrower pays interest to the lender each year. Once the money is paid back, and all interest payments are made, the parties are no longer bound together.
Inevitably some of the people who lent out money will need it back before the contract is up. To do this, they must sell ownership of the I-Owe-You note, similar to how stock owners sell shares.
If you sell a bond before it matures, you may receive more or less than what it was issued for (i.e., the par value), as bonds match their printed interest rate to current rates by adjusting their current price. The reasoning for this is that the discount or premium over the par value offsets acts as a secondary form of interest profit (or deduction).
Example: $1,000 bond maturing in 12 months pays 5%, but interest rates are 2%. Thus, the bond sells for $1,029.41 in the market. By raising the price, the interest rate is lowered by 3%. Rather than doing such math by hand, I recommend using a calculator, like this one.
Now, because bonds represent debt, there is always the chance a borrower could default and not repay the issuer. With high-quality obligations, such events are unlikely, but with lower quality debts, the chances are higher. Resultingly, high-quality debts pay lower interest rates than lower-quality debts.
Lastly, there is no insurance to protect you from a bond default. So spread your risk out by buying an indexed bond mutual fund or ETF.
Certificates of Deposit (Medium To Low Yield)
Certificates of deposit come in two flavors, similar to bonds. However, they are not corporate and government, and instead, they come in traditional and brokered certificates of deposit.
With traditional ones, you deposit money with your bank and agree to a period when the funds must remain for a given profit (i.e., interest rate). Generally, traditional certificates of deposit pay compound interest that accrues daily. If you decide you need your money back sooner than the agreed-upon duration, you will pay the bank a penalty for early redemption. After all, the bank loaned out your cash and hadn’t planned to repay you yet.
With brokered certificates of deposit, brokerage firms buy them from banks in large quantities, securing higher interest rates but passing fees onto you. Interestingly, unlike traditional certificates of deposit, brokered ones can be bought and sold during market hours and fluctuate in value, similar to bonds, based on their printed interest rate compared to the current rate.
Notably, though, brokered certificates of deposit (usually) pay simple interest-only versus compound interest like their traditional brethren. Thus, brokered ones only receive interest on the principal and not on additional interest accrued.
Finally, most certificates of deposit, both brokered and traditional, are FDIC insured. With traditional banks, that means coverage up to $250,000, and with brokerages that do cash sweeps, that can entail FDIC insurance of $1,250,000 or more (however, it depends on the firm).
Money Market Funds (Lowest Yield)
Money market funds are different than bonds and brokered certificates of deposit. Instead of fluctuating in value until redeemed, money market funds always track a price of $1 for every $1 invested in them, paying out any interest at the end of each month through new shares.
With money market funds, you often buy a mixture of high-quality corporate and government debts (bonds and notes) maturing within the next 397 days. Importantly, these funds must have 30% of their assets in highly liquid securities, and thus they are liquid and unlikely to default.
Due to their short-term nature and low-risk profile, money market funds provide lower interest rates than bonds and annuities but higher rates than traditional savings accounts. However, they offer no insurance to protect against default, unlike conventional bank accounts. Additionally, the proliferation of high-yield savings accounts has given them a run for their money in the past several years.
As a rule of thumb, money market funds tend to track the federal reserve rate closely, also known as the fed funds rate. Such makes sense since money market funds primarily track short-term debts denominated in large amounts of US government debt. As a result, if the fed funds rate is low, money market funds will pay little. If the fed funds rate is high, money markets will pay more. So, during our current economic climate in 2021, don’t expect to make much using these funds!
Regarding risk, while money market funds could dip below $1 per $1 invested in them, that has only happened once, and it occurred during the Great Financial Crisis. Since then, reforms have been implemented to mitigate risks further for investors in this asset class.
Insurance Products & Agreements
Annuities are a contentious product, as are many insurance products for those in the financial independence community. Before working as an advisor in the financial services industry, I was revolted by them. However, my views have changed, and now I view them as essential tools.
Notably, though, I believe that annuities are oversold and are a niche versus everyday product. Few people are risk-averse to where annuities are warranted. Nevertheless, they can be great for those who are or have other extenuating circumstances that require their use. However, I will cover annuities in-depth in my next article, as they deserve a post of their own due to their intrinsic complexity. Importantly, if you cannot understand the annuity contract, you should avoid it or you are likely to be taken advantage of by a salesperson.
So, join me
next week here! And, have a great day.
Mile High Finance Guy
finance demystified, one mountain at a time