Looking for Higher Yields? Avoid These Mistakes
Higher interest rates are primarily favorable, but investors must also watch out for pitfalls.
Since the Federal Reserve began raising interest rates in 2022, the Fed has raised its benchmark fed funds rate to 5.25 to 5.50%, the highest level in 22 years. Twenty-four months ago, yields on 10-year government bonds were under 2%. They’ve more than doubled since then, as the Federal Reserve hiked interest rates 11 times to bring inflation back to historical averages. Long-term government bonds yielded 1.90% at the end of 2021 and currently yield about 4.5%, a substantial increase in yield over a short period, especially after the prolonged low-interest environment since the financial crisis of 2008-2009.
Higher interest rates raise the long-term return prospects for fixed-income instruments, such as bonds and other short-term assets, so that investors can earn a higher rate of return without having to move into riskier asset classes, such as stocks.
But higher yields also bring potential pitfalls:
Being Complacent with Cash Holdings – Your financial institution won’t automatically move you into a higher-yielding option if you’re in a low-yielding cash account. You must check your interest rate to ensure it is attractive relative to the market.
Over-allocating to Conservative Investments – Certificates of deposit, money market funds, and I Bonds have been very popular investments recently. It is easy to become attracted to the certainty these investments offer. Still, it’s also important to recognize that the current higher yields on these investments can go down over time. This can leave you with limited options to reinvest the cash in the future, ultimately lowering your long-term returns. This type of risk is known as reinvestment risk.
Forgetting about Taxes – Investors need to also remember that CDs (short-term and long-term) are generally taxed at ordinary income rates, which can reduce the stated or advertised yield an investor expects to receive.
In comparison, for example, long-term capital gains taxes associated with stocks (that are held for longer than one year) are lower than an investor’s ordinary income tax rate. So, you should look at after-tax returns when assessing a CD versus other investment opportunities.
Forgetting about Inflation – Another way today’s yields can be tricky is that they don’t reflect the harmful effects of inflation on whatever payout you can earn. Cash investments usually keep pace with inflation, but barely. Other asset categories generally compare more favorably here. Real yield refers to the rate of return a fixed-income investor earns from interest payments after factoring in (or subtracting) the inflation rate.
Trying to Get the ‘Most’ Yield – Investors that prioritize yield over total return and risk-adjusted returns can get themselves into trouble (see an article on bond investing we contributed to here (https://fortune.com/recommends/investing/how-to-buy-bonds/).
Ignoring Asset Location – The type of account you use (taxable, tax-deferred, tax-exempt, etc.) to hold income-oriented investments can make a big difference to your returns. Asset location means that you want to hold your assets (and particular investment strategies) in different types of accounts from a tax perspective. Considering which account should hold which investments is an essential strategy often overlooked. It can help investors with both taxable and tax-advantaged accounts reduce their taxes. Paying attention to asset location can improve your portfolio’s after-tax returns and allow you to keep more of what your investments earn.
Not Being Vigilant with Asset Allocation – Generally, we recommend a combination of stocks, bonds, and, in certain instances, cash or cash-related investments. The correct percentages and investment selections should be customized and depend on your personal situation and circumstances. Asset allocation (and diversification) are two of the most important factors regarding your long-term investment returns and success.
Conclusion
Higher interest rates increase an investor’s expected purchasing power for the long term. This is especially true if inflation continues to decline back to historical averages. However, it is important not to lose sight of the forest for the trees.
