If you're a fixed-income investor, here's what to invest in ... and what to avoid
Consider short-term bonds, fixed annuities and investments in lar g e U.S. multinationals that pay dividends.
Steer clear of long- or intermediate-term bonds and balanced or target-date funds.
This economy may make it difficult for fixed-income investors to find safe income, but it's not necessary to get 5 percent to 6 percent interest on fixed-income investments when inflation is under 1 percent.
If you are living on a fixed income, it can be challenging to invest money safely while also getting a reasonable return on your investment. Money market funds and certificates of deposit are barely keeping up with inflation, and longer-term bonds are threatened by indications that the Federal Reserve will continue to raise interest rates.
Here are some suggestions for what fixed-income investors should consider and what to avoid.
What to consider
Short-term bonds. Consider a diversified portfolio of short-term bonds or, for investors in a high tax bracket, short-term municipal bonds. Short-term bonds pay higher interest rates than money markets or CDs. In addition, they will typically lose very little principal relative to longer-term bonds should interest rates go up.
Fixed annuities. Fixed annuities currently guarantee a minimum return of 2.5 percent to 3.5 percent, and the income is tax-deferred, which makes them even more valuable for taxable investment accounts. It is also important to realize that fixed annuities won't lose principal should interest rates go up.
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Large U.S. corporations paying dividends. High-quality, large multinational U.S. corporations that have provided consistent increases in dividends for 10 to 20 consecutive years are another avenue to consider. For example, look at the S&P Aristocrats Index or the exchange-traded funds that represent this index. These stocks are very large, and they dominate their markets.
These companies are not going bankrupt. They will be around a long time, and a diversified portfolio paying out 2 percent to 3 percent in dividends annually will go a long way in supplementing the lower income received on fixed-income investments. You will also get long-term growth and can wait a long time for market corrections to recover when your stock portfolio is consistently providing dividends of 2 percent to 3 percent annually.
What to avoid
Long- or intermediate-term bonds. Stick with short-term bonds (less than three-year durations). Longer-term bonds will lose too much principal when interest rates go up.
Balanced funds. These funds hold 40 percent to 60 percent bonds, with average maturities of eight to 12 years. This means half of the investments in these funds will lose money as interest rates go higher.
Target-date funds. Target-date funds are very misunderstood by investors. They are marketed as an investment that will automatically be adjusted to be less and less risky as the investor gets closer to retirement. The problem is that to make the funds less risky, they invest more of the fund's portfolio into bonds (eight to 12-year maturity). In an environment where the Fed intends to raise interest rates, these funds are becoming riskier the closer investors get to retirement.
While this economic environment may make it difficult for fixed-income investors to find safe income, remember that we also have very low inflation right now. Therefore, it's not necessary to get 5 percent to 6 percent interest on your fixed-income investments when inflation is less than 1 percent. If you're living on a fixed income, it is important to maintain the purchasing power of your savings.
However, getting a 3 percent return when inflation is 1 percent is the same as getting 6 percent when inflation is 4 percent, at least as it relates to purchasing power.
(Editor's Note: This article originally appeared on Investopedia.com .)
— By Vern Sumnicht, founder and CEO of Sumnicht & Associates
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