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Recent actions by the Federal
Reserve will have a big impact on the interest rates paid on
investments. Their actions mean you may need to use a
different strategy if you depend on your investments for
income! Read on to find out how you can boost your income
with little risk, but only if you are patient.
The Federal Reserve increased the interest rate banks charge
each other for the first time in four years. Sure, the
modest increase from 1% to 1.25% may not seem like much, but
it signals a major shift in the Federal Reserve’s handling
and perception of the U. S. economy.
Interest rates are the tool the Federal Reserve uses to
encourage economic growth and to keep inflation under
control—similar to the brake and accelerator on a car. Over
the last 4 years the Federal Reserve has been pressing the
economic accelerator by moving interest rates to 46-year
lows. And it worked.
The problem is that the faster the economy grows the more
risk there is of inflation. So, in an effort to keep the
growth on the right track, the Federal Reserve has tapped
the brakes by slightly increasing interest rates. The
economy is strong and the Federal Reserve is expected to
continue modestly raising interest rates over the months and
years ahead.
That is good news for income oriented investors. But you
must be patient.
Bank Certificates of Deposit (CDs) are my bond investment of
choice right now. They yield more than Treasury bonds and
about the same as corporate bonds that have more risk. But
don’t be in a rush to lock your money up longer term,
because the interest rates look better than they have in
years.
It doesn’t make sense to lock your money up for long periods
of time when interest rates are going up. For instance, in
just the past two months, interest rates on 1-year CDs have
jumped from 2% to 2.4%. So by just waiting 2 months, you
could have increased in your interest income by 25%.
Right now the Federal Funds rate is 1.25%, but the futures
market is predicting that it could be as high as 3% by the
end of 2005. That means the interest paid on 1-year CDs then
could be twice as high as it is now. It is likely that by
the end of next year you will be able to earn 4%, 5% or even
6% on ultra-safe Certificates of Deposit.
So if you are an income-oriented investor, now is the time
to use short-term investments. But be patient. Don’t put all
of your money to work right away. The safest way to invest
in this environment is to ‘ladder’ your maturities.
For instance, if you have $300,000 of your investment
portfolio allocated to bonds, divide it into two portions.
Invest $150,000 in a 6-month CD and the other $150,000 in a
1-year CD. Each time one matures, you reinvest that money
into another 1-year CD. That way you have a portion of your
money coming due every six months and can reinvest it at a
higher rate. It’s a wonderful way to ride the tide of rising
rates and maximize your returns.
Another great deal right now can be found in municipal
bonds. For instance, municipal bonds with a 5-year maturity
are currently yielding around 4.9%, whereas a 5-year
Treasury Note is only paying 3.9%. Plus, you don’t have to
pay Federal Income Tax on the interest earned on municipal
bonds. The Treasury Note would have to yield over 6.7% to
give you the same amount as the municipal bond after taxes
assuming you are in the 27% tax bracket.
Although I have used mutual funds that invest in bonds in
the past, I am not using them now. In fact, I have moved all
of my client’s money out of bond mutual funds over the last
12 months. As interest rates rise, I will be putting that
money back to work using short-term Certificates of Deposit
or municipal bonds.
So be patient. Divide your money between 6-month and 1-year
Certificates of Deposit. Avoid tying your money up for more
than a year. That way, you will be able to ride the rising
interest rate wave and see your income safely increase.
Mr. Voudrie is a Certified Financial Planner, nationally
syndicated newspaper columnist and President of Legacy
Planning Group, Inc., a Private Wealth Management Firm in
Johnson City, TN. You can receive free, clear, unbiased
advice toll-free at 1-877-827-1463 or at
jeff@guardingyourwealth.com.
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