Poof! Those plump 5% high yields on cash that investors got used to are going, going and almost gone.
The Federal Reserve's jumbo-size half-point rate cut this month marks the start of a lower-interest-rate environment. Inflation, hovering around 2.5%, is finally close to the Fed's 2% target. And the central bank's focus now is to keep the job market from weakening.
"We know which way the wind is blowing," said Greg McBride, chief financial analyst for Bankrate.com. "Yields are going to continue to fall."
Rates Are Falling
The Fed's key borrowing rate is now in the range of 4.75% to 5%. And the September dip in consumer confidence — the biggest since August 2021 — now has Wall Street pricing in 59% odds of another half-point rate cut at the central bank's next meeting in November.
So, there's a chance in six short weeks that savers could be looking at a rate of 4.25% to 4.5% — a full percentage point lower than at the end of the summer.
That means savers will have to move quickly to lock in higher rates on their money before the Fed cuts again. It also means fixed-income investors will need to explore different corners of the bond market if they're still bent on earning yields near or north of 5%.
No doubt, earning 5% on cash and bonds without taking on too much added risk is getting harder. "But it's not impossible," said Lawrence Gillum, chief fixed-income strategist at LPL Financial. "There are still ways to generate around 5% in portfolios."
So, how should savers and fixed-income investors play things now?
Lock It In
Lock in higher rates while you can. Rates on money markets and savings accounts are headed lower. There's not much you can do about that aside from shopping around for the very best rates.
So now's the time to lock in current rates, which are still well above the 2.5% inflation rate, in products like CDs. But this isn't the time to dillydally.
"Move quick," said McBride. "There's no advantage to waiting. Yields have already come off the peak."
Both savers and retirees can still lock in decent, inflation-beating yields on CDs, says McBride. There's often a lag between when the Fed slashes rates and when banks adjust yields lower. So, act now.
Construct A CD Rate Ladder
McBride recommends building a CD ladder. This strategy puts equal amounts of money into multiple CDs with different maturity dates. For example, if you have $50,000 in cash now sitting in a money market, you could invest $10,000 apiece in a one-, two-, three-, four- and five-year CD.
While there are still some one-year CDs yielding 5%, they're vanishing fast. Building a ladder will likely enable you to lock in yields in the 4%-4.5% range over a five-year period.
The benefits are threefold. You lock in higher rates for longer. Your yield will outpace inflation. And you'll be able to create a smooth stream of income and have regular access to cash every 12 months for spending needs or reinvestment.
But there's a catch: "You have to put your money in the right CDs," said McBride. "Seek out the top-yielding, most competitive offers."
Stack Your Bond Portfolio With High Yields
To lock in current yields, Brad Bernstein, private wealth manager at UBS Private Wealth Management, recommends building a bond ladder, similar to a CD ladder. He's been building municipal bond ladders for clients with maturities ranging from one to 15 years, and five to 20 years.
"So, if you do a five-to-20-(year) muni bond ladder, you have funds coming due in five, six, seven, eight, nine years, etc., and every year for 20 years," Bernstein said.
Locking in longer-duration bonds means investors can secure higher yields for longer. And they can also benefit from capital appreciation in coming years as yields fall and prices rise.
Get Preferential Treatment
Another option is to buy preferred securities. Better known as "preferreds," this higher-yielding investment has a mix of bond- and stock-like features. While they trade on the stock exchange, preferreds allow investors to own high-quality companies and get a fixed-rate return that is typically paid out in a quarterly dividend for a fixed period of time, such as five years.
"We like preferreds because they have yields above 5%," said LPL's Gillum.
No doubt, what makes preferreds attractive is the plump yields they offer. Investors in search of yields of 5% or more might consider preferreds. The iShares Preferred & Income Securities ETF, for example, has a current annual yield of 6.20%, according to Morningstar. Similarly, the Invesco Preferred ETF yields 5.64%.
These higher yields are also attractive in that the investments are in high-quality companies with a lower probability of default than riskier high-yield bonds.
Another perk is dividends on preferred securities are taxed as qualified dividend income at a federal rate of 15% of 20%. That's a good thing for investors in higher tax brackets, as they will face lower tax bills than they'd pay on income.
Consider Assuming More Risk For High Yields
You might also take on a tad more credit risk to boost yield. Yields on so-called risk-free assets like Treasuries have been falling as Wall Street prices in Fed rate cuts. That means investors can eke out a little more yield by taking advantage of the spread offered by more risky bonds. For example, investment-grade corporate bonds now have a roughly 1% spread above risk-free Treasuries.
So, using a back of the envelope calculation, if the 10-year Treasury now yields around 3.75% a corresponding investment in an investment-grade corporate bond can fetch, say, 4.75%, or close to income investors' 5% target.
"If you take on some additional credit risk, you can increase your yields," said Gillum.
Think Long Term For High Yields
Another strategy is to extend the duration on your cash. It's largely accepted that rates paid on cash are heading lower. That's why Gillum recommends taking money out of cash holdings and reinvesting in high-quality bonds, including Treasuries or investment-grade corporates, with maturities of no more than five years.
"We're saying go out five," said Gillum. The logic is simple. You gain a little more yield but avoid the added volatility if you invested in longer-term bonds with maturities of 10 years or more. Currently, there's a small so-called spread between two-year Treasuries (which yield 3.553%) and 10-year Treasuries (which yield 3.779%). But that spread between short and long rates is seen widening.
Mind Your Tax Bill
Consider tax-friendly municipal bonds. Yields are still attractive on so-called muni bonds, says Bernstein. And when you factor in the tax-equivalent yield of these bonds, which aren't subject to federal taxes and are usually exempt from state taxes, the yields look even better.
"You could buy a high-yield muni bond fund now and get a little over 5% tax-free," said Bernstein.
Here's how the math stacks up, according to Raymond James' weekly muni bond update. An AAA-rated muni now yields 2.61%, which equates to a tax-equivalent yield of 4.4%. And an A-rated muni yields 3%, which sports a 5.07% yield once tax savings are factored in. Both of those tax-equivalent muni yields are higher than the 10-year Treasury yield of roughly 3.75%.
"The fundamentals of municipalities are still pretty solid, and a lot of states have a lot of cash on their balance sheets to weather an economic storm," said Gillum.
Don't Reach Too Far For High Yields
The one thing you don't want to do is to stretch for yield, or make the mistake of taking too much risk in search of higher yields, warns Ryan Zabrowski, a senior portfolio manager at Krilogy, a wealth management and financial planning firm.
It's important to do some research and see how the more risky bonds you're considering buying performed in down markets, says Zabrowski. "You really need to understand how those investments performed under stress economic situations and what the range of outcomes are," Zabrowski said.
