Risk and reward are opposite sides of the coin. Whenever you earn higher interest rates, you?re taking on more risk. Here?s how to evaluate those risks.
First, you need to look at the lowest risk returns available now: the returns on very short-term U.S. Treasury bills or insured bank money-market deposit accounts. According to Bankrate.com, the average rate on an FDIC-insured money-market deposit account is 0.79 percent, though some banks offer as much as 1.30 percent. If you?re willing to take a longer-maturity CD, you could earn the national average rate of 1.34 percent on a one-year CD or 2.85 percent on a five-year CD. You?re paid more interest on these longer-term CDs because you?re taking on more risk. It?s not a safety risk because your CD is insured up to FDIC limits. Instead, you?re taking on the risk that interest rates might rise in the next year, or five years, leaving you locked into a low-yielding investment. That?s why banks must offer a higher interest rate.
If you break out of your CD early because you need the cash, you?ll pay a penalty. Similarly, if you purchase a bond, you?ll also pay a penalty for selling early when rates are rising. But in this case, the marketplace determines the penalty.?
Here?s the principle: When interest rates rise, bond prices fall. Think of it this way: Suppose you spend $1,000 to purchase a 10-year government bond yielding 4 percent. Then the general level of interest rates starts to rise ? either because of fears of inflation or because the economy starts growing again. Then the government has to borrow money again, so it issues new 10-year bonds, carrying an interest rate of 5 percent or 6 percent ? or even 8 percent. Anyone who had kept cash in a money-market account and waited for higher rates could then purchase a $1,000 bond paying 8 percent interest.
If you wanted to, or needed to, sell your old 4 percent bond, no one would pay $1,000 for it because their cash could buy a much higher-yielding government bond. In fact, the price probably would drop to around $650 in the bond-trading marketplace. Of course, you could hold on to your 4 percent bond for the remainder of the 10 years until it matures. But in the meantime, you?d be stuck earning a lot less interest.
That?s the concept of ?interest rate risk.? Bonds rise and fall in value, in the opposite direction of interest rates. The longer the maturity of the bond, the bigger the potential swing in price. If you lock your money up for only three years, you might not worry so much. But if you?re considering a 10-year bond, you have to consider the outlook for inflation and higher interest rates.
There?s another risk in buying bonds: ?quality risk,? basically the risk that the borrower (either a company or government) won?t be able to pay the interest in the years ahead, or repay the principal when the bond matures. That?s why bonds carry ratings. The top-rated bonds ? either from corporations or states and municipalities ? carry ratings starting with AAA at the highest level. The lower the rating, the higher the rates they must pay to borrow. When buying tax-free state or local government ?municipal bonds,? consider the quality risk. The recession has slowed state tax revenues, while promises for education to pensions to prisons keep costing more. And the more states are hurting, the higher the interest rate they must pay to get you to lend them money by purchasing their bonds.
Before you jump at higher yields, ask yourself about the risks you?re taking: either the risk that rates will rise and you?ll be stuck, or the risk that comes with the nagging worry that your interest or principal payments might not be secure. There is always a risk when you earn more than the safest investments pay.