Cash in on 23-year high interest rates with this safe, CD-beating investment
Americans have salted away nearly $17.4 trillion in bank deposits.
But despite the Fed’s 23-year high interest rates, banks have been notoriously slow to raise deposit rates.
One way to cash in on higher rates is to invest in government bonds. But to avoid a stomach-churning roller coaster ride of price spikes and plunges, it’s important to choose the right ones.
The short answer to which bonds to buy is, well, to buy short-term bonds.
To see why, you need to understand two things about the bond markets. The first is what types of risks you must avoid. The second is how interest rates and prices affect each other.
Risks and rewards
The risk of any investment—including bonds—can be broken into two parts.
The first is credit risk—the risk you will not be repaid if the borrower goes bust. The best way to avoid that is to invest in U.S. government bonds.
Because the government can raise taxes to pay its debt, there’s almost no way it will default (absent foolish legislative brinksmanship over the debt ceiling). There is, essentially, no credit risk to worry about.
The second type of risk is market risk. This is the risk most people think of when buying assets like houses or stocks. It is the risk that the investment will decline in value.
U.S. government bonds will always pay back 100 cents on the dollar at maturity, but over the course of their life, their prices can fluctuate quite a bit.
If you own a 20-year bond but need to sell it in seven years, there’s a chance you will have to take a loss if the price in the seventh year happens to be below 100 cents on the dollar.
Here’s what moves bond prices
Interest rates and the prices of bonds move in opposite directions.
That’s because if interest rates on new bonds rise, old bonds with lower interest rates (called “coupons”) must fall in price to attract buyers.
Say you have a bond that matures in a year with a 10% coupon. Rates rise by one percentage point, and the government issues an identical bond with an 11% coupon.
To stay competitive, your bond will have to fall in value by 1% in order to be as valuable as the new bond. If you must sell it before rates fall back to 10%, you will lose 1 cent on the dollar.
Here’s an example.
- You buy a bond with $100 face value and a 10% coupon for a yield to maturity of $110. Yield to maturity is your total return on the bond.
- Interest rates go up and the government issues an identical bond, only with an 11% coupon, for a yield to maturity of $111.
- For your bond to stay competitive, it must decline in value by 1%. Then, the interest rate at maturity will be $110 and the value of the 1% discount will be $1, so the yield to maturity will be $111—the same as on the new bond.
This is why bond prices fall when interest rates rise, and vice versa.
Today’s bond anomaly—or what’s that pesky “inverted yield curve”?
If you plot all the government bond interest rates on a graph, you get what’s called a yield curve.
As shown below, today’s yield curve is sloping downward because short-term bonds have higher interest rates today than long-term bonds—which is unusual.
That’s because, in theory, the longer the timeframe, the higher the risk—and, in turn, the higher the reward (i.e., yield).
If yields take the opposite direction, it's called an “inverted yield curve.”
There’s a lot of nuance to that, but in short, it’s often a sign that a recession is about to start.
If a recession does start, or the economy begins to slow, the Fed will have to cut short-term rates, which will cause the economy to recover and push up longer-term rates.
That means that investors who buy short-term bonds today get a better interest rate now and the possibility that their investments will rise in value when the Fed decides to cut rates.
By contrast, those who buy long-term bonds today get a lower rate now and the possibility that their bonds will fall in value when the Fed cuts interest rates.
Maturities matter
This all matters because bond prices do not all respond in lockstep to changes in interest rates.
Short-term bond prices only move a little—they retain almost all their value. Long-term bond prices move a lot, and investors can lose significant amounts of money on them.
So canny investors looking to take advantage of today’s high interest rates would do well to invest in shorter-term bonds, especially those three years or less in maturity.
They can do that through money market mutual funds, short-term bond mutual funds, or exchange-traded funds (ETFs) that track bond indexes.
The table below shows four different ETFs offered by Blackrock under its iShares product line. Each ETF tracks a different government bond index comprised of bonds with different maturities:
- Floating rate (ultra-short term) bonds
- 1-3 year Treasury bonds
- 3-7 year Treasury bonds
- 20-year and longer Treasury bonds
Note that the best returns year to date were in the ultra-short government bond product.
The worst (a loss of over 5%) was suffered by the 20+ year government bond product.
The relationship between bond interest rates and prices is actually far more complicated than the explanation above implies.
But all an investor looking for a bank-beating return on high interest rate bonds needs to know right now is this: the shorter the maturity, the lower the risk, and the higher the possibility for a nice windfall when the Fed cuts rates.