Let’s face it. It’s been quite the dry spell for conservative savers. Interest rates are historically low, and they have been quite low for some time.
Risk vs. Reward
In such an environment, it is really easy to get discouraged. After all, what is the point of putting cash into a savings account when I am hardly compensated to do so? At the same time, it is also easy to be tantalized by the prospect of pursuing higher yields elsewhere. Generally speaking, the tradeoff with higher yields is that you incur additional risk – either to the sustainability of the yield received, or to the certainty that you will receive all of your initial investment back.
In this post, I’m going to consider the available options and the criteria to assess what might make sense.
Safety of Principal
In theory, investors demand a certain rate of return even when they incur zero risk to their principal. In practice, however, there is no such thing as a perfect investment with zero risk.
When I was taking finance classes, the commonly accepted assumption for an appropriate risk-free rate was around 4%. Generally, this was taken from the prevailing rates from U.S. Treasuries. Current rates have not been very appealing. As of June 2015, the 3-month T-bill yields a whopping 0.00%. Since the U.S. has seen its credit rating downgraded in the past few years, it’s not even clear to me whether U.S. Treasuries still represent the closest proxy for a risk-free instrument.
I would break down safety of principal into what is perceived and what is realistic. The most apparent form of perceived protection comes from Federal Depository Insurance Corporation (FDIC) insurance, which is an implicit government insurance program that protects deposits up to a certain amount (currently $250k). This coverage amount is per depositor, per insured bank, and for each account, so an investor could actually receive quite a bit of coverage once all of those coverage limits are aggregated. The types of accounts covered include checking accounts, savings accounts, money market deposit accounts, and certificates of deposit.
FDIC coverage has provided the most comfort to investors, as that coverage is backed by the “full faith and credit of the United States government.” Moreover, the FDIC can also draw on a line of credit with the U.S. Treasury if it is ever necessary. Since its founding in 1933, no depositor has ever lost any money of FDIC-insured deposits.
The counter to this protection is whether the FDIC is sufficiently capitalized to survive a bona fide financial crisis. A viable insurance company would need to have adequate funds to cover its obligations. The FDIC should be subject to similar standards. It certainly surprised me to discover that the FDIC does not actually receive funding from the government. To cover any bank failures, the FDIC maintains a Deposit Insurance Fund (DIF) that is funded by premiums paid by member banks. The FDIC is required to maintain a designated reserve ratio in this fund, which has been determined to be 2.0%. On the surface, that seems pretty low. In actuality, it’s even lower. As of December 31, 2014, the DIF has a balance of $62.8 billion and a reserve ratio of 1.01%. This marked five straight years of DIF balance growth from a low of negative $21 billion in 2009. The Dodd-Frank Act set a minimum reserve ratio of 1.35% that the FDIC needs to reach by 2020.
When the FDIC was first started in 1933, the insurance coverage limit was $2,500. The coverage limit has since been raised multiple times. The most recent raise occurred in 2008 in the depths of the financial crisis when the limit was moved from $100,000 to $250,000. While inflation has been significant since 1933, I’m pretty sure that it hasn’t been 100x.
For an insurance fund that is meant to cover bank deposits measured in the trillions of dollars, it is a bit scary for me to imagine what might happen if we did experience multiple bank failures. The FDIC is a “symbol of confidence,” but is it actually a legitimate insurance fund? In a major crisis or other black swan event, it would seem likely that special emergency injection by the federal government would be essential to cover any shortfalls. These symbols are perceived to be bulletproof until they are not. Credit ratings had been regarded nearly as gospel until their integrity was questioned during the crisis.
This is not meant to incite panic. It is meant to illustrate what the reality of the situation is. As with any potential investment, you cannot take the marketing at face value. This is what I mean when I say there is a difference between what is perceived and what is realistic.
Optionality (0% Yield)
Cash is king. I realize that with lofty prices in many asset classes, cash seems to be in abundance right now. But there has never been a boom that has persisted. When the environment eventually normalizes and potentially swings to the opposite extreme, having available cash on hand will prove to be very valuable. Here is an interesting post that demonstrates that doing nothing for 5 years but then finding superior returns for the ensuing 10 years will yield better results than 15 years of mediocre returns.
Cash held in brokerage accounts will likely not earn much in interest. Fortunately, there are options that will let you earn a bit more yield while keeping liquidity constraints to a minimum.
FDIC-Insured Alternatives (1% Yield)
Having opened your eyes to the limitations of the FDIC, it is still generally preferable to hold money in an account that is FDIC-insured as opposed to an account that is not FDIC-insured. I say generally because it really depends on how you are compensated for the risk that you are taking on. We’ll examine those later on, but understanding what you are
Chances are you are being paid a pittance in your current FDIC-insured account. Most of the major banks have rates that are measured in basis points.
A quick scan of Bankrate shows multiple options that will produce a 1% yield. I use GE Capital bank which currently has a 1.05% yield. Surprisingly, these rates are higher than most short-term CDs, even though these accounts do not require you to keep your funds there for a set time period.
CD ladders are also a popular option. There are several 5-year CD options that yield about 2%. It’s admittedly not a super compelling rate, and I’m not sure if tying up funds for that period of time is worth an extra point of yield.
A quick note on taxes too. If you happen to be in an Obamacare income bracket, and if you happen to live in a state with high income taxes like California, the net income that you receive from your interest income is going to be paltry – approximately 45% to 50% of your interest income will be paid out in taxes.
Index Funds / ETFs: Bond or Equity or Dividend (2%+ Yield)
Once you let go of the FDIC-insurance requirement, there are opportunities to get more yield. Unfortunately, you are now also subject to volatility in your principal.
Time horizon is a pretty critical consideration here. As a place to stash cash for the short-term, this is probably not the best alternative. If there is a sudden downturn, you will not want to be in a position where you would need to liquidate at a loss. Once again, you need to ensure that you are being adequately compensated for the risk you are taking on above the FDIC-insured alternatives.
However, if you have a long time horizon and would be willing to hold on (by tapping other investments or savings for necessary cash) or tax harvest in a downturn, then it might make sense to take on this risk. Most prudent investors are likely contributing periodic amounts to these types of investments anyway, and this is a way to add more yield by adding amounts that might have gone toward cash. If the price increases, then you would happily liquidate and use the cash elsewhere as originally intended. If the price decreases, then you would just attribute it as a long-term investment and hold on. This assumes that you don’t actually need to use the cash in the first place, which might be a luxury that not many of us have.
An interesting way to tailor your holdings here would be to consult the credit ratings of the individual companies in the major index funds and ETFs. For example, you could choose to invest only in companies with a certain credit rating or better. There are actually only 3 companies that currently possess an AAA rating: Exxon Mobil (3.4% dividend yield), Johnson & Johnson (3.0%), and Microsoft (2.7%). You might choose to widen your net to include A or AA companies, and you’ll need to pay attention to transaction costs. However, the benefit of the credit ratings in this context, while not a pure assessment of the likelihood of the business to continue to support and grow the dividend, is that you’ll at least have some comfort in the financial strength of these businesses.
The tax implications are also worth highlighting. Most dividends will be paid at long-term capital gains tax rates, which means more of the income stream will net to the investor relative to interest income.
Preferred Stock (~5%)
Now, we are looking at some more unconventional alternatives, so be sure to do your own research beforehand. Preferred stock is senior to common stock, but is junior to most debt. They also generally pay a heftier dividend than common stock and bonds. However, these securities also have a lot of terms that may vary depending on the specific issuance.
I use Quantum Online for most of my research into preferred stock. You’ll notice that most of the issuers are financial institutions, and that you can often earn a higher yield on their securities than in their saving account products. Take Wells Fargo as an example:
- Savings account and CD interest rates: 0.01% to 0.50%
- Common stock dividend yield: 2.60%
- Wells Fargo bonds: ~1% to 5% YTM depending on maturity
- Wells Fargo Series O Preferred Stock: ~5.5% YTM (callable in Dec 2017)
Wells Fargo likely has one of the strongest reputations among financial institutions. Yet, relative to the rates that you can earn in the savings accounts that Wells offers, you can potentially earn a lot more investing in different parts of the company’s capital structure.
For preferred shares, there are a lot of unique risks that are introduced, including default risk and the risk that the company suspends its dividend payments. However, this is an example where the additional yield may adequately compensate the added risk exposure.
There are many option strategies that can generate income, but I’m going to focus on one particularly strategy that is fairly conservative as far as option strategies go: selling cash-secured put options.
We can take a look at Wells Fargo again as an example, which is trading at about $57. If we are comfortable owning the stock at a lower price (say $55), we can sell a cash secured put to take the option premium today. An option that expires in January 2017, or in about 18 months, currently sells for $5 per option contract, or at an implied 9% yield based on the strike price of $55. Annualized, this is about 5%.
Wells Fargo is not even the best example, since it tends to not be very volatile. The higher the implied volatility of the stock, the greater the potential yield by selling puts. This strategy works on ETFs as well, and might be a good way to earn extra income while waiting for a good entry price.
The risk is that if there is a downturn, you may be committed to purchasing the stock at a higher price than the prevailing market price at the time of expiration. However, as long as you consider only stocks that you would be willing to own, and at prices that you would be willing to own them at when you set the strike price, then all of the potential outcomes should be fine.
So where does that leave us? This might seem like dodging the original question, but to me, the only solution to all of this uncertainty is to be diversified across all of these options. How one chooses to allocate assets across these options is a personal decision since each option has its own risk/reward tradeoff, and it’s not necessary to be exposed to all of these alternatives. I would probably prioritize optionality and safety of principal, which means that I’ll be holding on to more cash, even though I will still deploy some capital in the other categories.
As always, remember Warren Buffett’s first two rules of investing.
Disclosure: I may at any time hold, initiate or exit positions of any or all of the securities mentioned in this article.