Interest Rates and Returns

When I was young in the 1970’s I heard a discussion between my grandfather and my father. My grandfather was literally “grandfathered in” as a CPA; he was a practicing CPA prior to the test being a requirement to practice as a CPA so he was able to continue his work without ever taking the exam.

In the 1970’s inflation was endemic and interest rates were high; the Federal funds rate peaked at 19% in 1982. At the time my grandfather made the prediction that “interest rates would never go below 10%”. This seemed like a reasonable statement at the time…

Living in a “normal” interest rate environment, here would be some basic assumptions:

– bonds would give you a reasonable interest rate, maybe 5% to 10% depending on conditions
– stocks would give you price appreciation, plus a dividend yield (overall) of maybe 2% – 4%
– these items would barely keep you up with inflation

In today’s interest rate environment, the US government is keeping interest rates effectively near zero. They are doing this to help the economy and it also helps the US government since we are issuing a lot of debt (running a deficit) and keeping a low interest rate allows them to raise money at a low debt rate (for as long as someone on the other side will keep buying it; the largest buyer of US debt is the US government under QE2 but that is a different question).

Regardless of governmental policy, here is the practical impact on my portfolio:

Bonds – here is my current “CD ladder” that I use in lieu of bonds:

CD’s Rate Duration (Years)
CD 3.9% Monthly due 12/19/11 3.9% 0.5
CD 2% Monthly due 1/19/12 2.0% 0.6
CD 4.1% Monthly due 12/17/12 4.1% 1.5
CD 2.2% Semi due 3/28/13 2.3% 1.8
CD 2.8% Monthly due 1/8/14 2.8% 2.5
CD 2.45% Monthly due 3/31/14 2.5% 2.8
CD 1.35% Semi due 6/24/14 1.4% 3.0
CD 2.9% Semi due 4/1/15 2.9% 3.8
CD 2.05% Semi due 6/29/16 2.1% 5.0

Average interest rate (assuming all CD’s are equal value) 2.6%
Portfolio “duration” in years 2.4

For those with advanced skills in this area I am not calculating my duration exactly right because I am not taking into account the effect of re-invested interest but frankly in this era of low interest rates it doesn’t throw my calculation off too much.

This CD ladder reflects a few things – I bought the highest yielding CD’s (online) and a lot of banks failed and were taken over, particularly in Puerto Rico. Although there was no principal loss (because the US government insures up to $250,000 and my individual bank exposures were lower than that) I had to re-invest the proceeds and by that time interest rates drifted even lower. In any case interest rates now are brutal; 5 years gets you 2%, and 3 years gets you 1.4%, and frankly less than 3 years and you might as well leave your money in the bank account (which will get you less than 0.2%, but is immediately liquid, and gives you more re-investment opportunities).

iBonds – the US government used to let you buy up to $30,000 / year in iBonds. Recently they dropped this to only $5000 / year (yes I know for those advanced people that this is per person, and if you wanted to not buy jointly which could cause some other problems later you could buy $5000 each and then $5000 in paper which also requires a trip to a bank and is a pain).

Why did they do this? Probably because today, due to inflation and the fact that I bought my iBonds when they had a “real” interest rate of more than 1% (it is ZERO today), my iBonds yield 5.78%. People would KILL for that risk free return today if they could get it; as you can see above 3 and 5 year interest rates are between 1.4% – 2%. Of course, if inflation dives or deflation comes, the return on iBonds plummets as well; at one point in 2008-9 the iBonds paid ZERO return on principal AND the adjusted inflation component. But for now these are doing great, if you were able to buy them before the limits tightened up.

Stocks

The crazy thing now is that STOCKS offer a similar yield in the form of dividends than BONDS do in the form of interest (for non “junk” debt). Here are some of the dividend yields that I am receiving today (ignoring price appreciation or losses):

Fund or ETF Ticker Yield

Vanguard Value Index Fund VFINX 1.64%
Vanguard Selected Value Fund VASVX 1.42%
Ishares Dow Jones Select Dividend Index Fund DVY 3.24%
Vanguard Emerging Markets ETF VWO 1.66%
Vanguard European ETF VGK 4.24%
Vanguard Total Stock Market ETF VTI 1.71%

Average dividend yield 2.3% (assuming all funds / ETF’s equally weighted)

Thus the dividend yield I am getting on this basket of funds and ETF’s is roughly equivalent to my return on CD’s, which approximates the Federal interest rate curve; this is not what we were taught to expect, at all.

Another element is that dividends are (currently) taxed at 15% while interest is taxed as ordinary income, which is 28% and above. Thus even if they are both roughly the same, dividends come out higher on tax efficiency, although there is a significant risk of capital loss (while the CD’s are far less risky).

In all financial situations you should do your own research and come to your own conclusions; I really didn’t see the total yield vs. interest rate situation brought home until I ran it with my own numbers.

Finally, in any era of super low interest rates, like today, retirement is almost impossible, because you can’t earn anything on your money. At 3% (let’s round up), that becomes about 2% when taxes are taken out, which means that if you have $1M saved up and earning income you are left with $30,000 before taxes. That is more than enough to live on if your needs are extremely modest but 1) the average American probably has less than $1M in income earning assets at retirement 2) $30,000 won’t do squat in any major metropolitan area. Thus retirement, unless you have a solid pension (generally from a government job, there are few other ones nowadays) or income producing assets like ownership in a business, is really just a time when you are drawing down assets rapidly towards zero, because at these low rates you are earning virtually nothing.