Examining Alternatives to Stocks

By Bob Moeller
WEAC Member Benefits

December 2002

Financial Planning Seminars
Achieving Financial Independence

We’ve recently been told that the earnings rate on the WEA TSA Guaranteed Account will be 5.0% for 2003. This is a drop of 1½%. Is the fixed rate still a good deal? Look at it this way: Interest rates are low. The safest investment around is U.S. Treasury debt. Today, a one-year bill pays about 1.7%, five-year 3.2%, and 10-year 4.2%. I am informed that the competition for TSA fixed interest looked as follows as of September 2002:

• AmExpress, 3.70%.
  
• Equitable (old money), 3.85%.
  
• Aetna, 4.25%.
  

Overall, to invest your money with no time commitment in a safe investment that will pay 5% for a year is an excellent deal these days.

Because of the big stock market drop, members want alternatives to stocks. Over the next few months I will cover a few alternatives. These will all be what I call “fixed” investments and will include bonds, CDs, and preferred stocks. Presumably you have less risk with these than you do in stocks.

Let’s start with bonds. A bond is debt. When companies or governments want to borrow money, they may issue bonds. If you buy a bond, you will usually receive interest every six months, and at the end of the term you will receive back the principal. You have two kinds of risk with bonds.

The first risk is the quality of the borrower. You do not want to loan money to XYZ Corporation unless you know it will be repaid. Larger companies and governments are “rated” by private rating companies, including Moody’s and Standard & Poor’s. The highest is AAA. Then, following in order AA, A, BBB, BB, B, CCC, etc. The ratings are further defined by +’s or –‘s, or by sub-numbers, such as A1,A2, A3. The lowest rating a company can get and still be considered “investment” grade is BBB- or BBB3. Anything lower is a “junk” bond. Of course, the lower the rating, the higher the yield. Government bonds are also rated.

Do ratings change? Yes.

RULE #1: Unless you accept the higher risks, never buy a bond below investment grade, and if conservative, stick to A rated or better. Make sure you ask if the company is under a credit watch.
The second risk you take when buying bonds is interest rate risk. If you buy a long-term, 15-year bond paying 6% today, and interest rates go up to 8% five years from now, your 6% bond with 10 years remaining will go down in value regardless of the quality of the company behind it.

RULE #2: When interest rates are this low, do not buy long-term bonds. Buy only bonds you are willing to sit with until maturity.
Following are some sample individual bonds and their rates as of October 28, 2002:

• Sears, 6.25%. You purchase a $1,000 coupon for $930, earn $62.50 per year and get $1,000 back at maturity on May 1, 2009, providing a yield to maturity (growth and interest) of 7.65% per year. The rating for this bond is Baa1/A, which is investment grade.
  
  
• GMAC (General Motors Acceptance Corp.), 6.55%. You purchase a $1,000 coupon for $912, earn $65.50 per year and get $1,000 back at maturity in April 2011, providing a yield at maturity (growth and interest) of 8% per year.
  

So, yes indeed, you can find yields above 5% today in investment grade companies. But it takes some work. How did I get these prices? I called a broker at Quick & Reilly in Milwaukee.

Willing to take a little more risk if still in investment grade?

Household Finance has many bonds out, one of which matures in 2006, pays $65 a year, sells for $910. You get $1,000 in 2006 plus interest each year, for a total yield to maturity of 9.85% per year. It currently is rated A2/A- by the two agencies, but is on a negative credit watch. That means Household Finance may be downgraded. (These are yields as of October 28.)

On the other hand, a downgrade two notches to BBB is still investment grade, and you get 9.85% a year in a short-term bond.

Sound like too much work? Individual bonds are not recommended unless you are prepared to spread out the risk in several issues with a total investment of at least $70,000. Of course, one very good alternative is to simply buy bond mutual funds. Since you get a limited annual return in bonds, every little bit you pay to a bond mutual fund manager has a significant impact on your yield.

Best bet? Consider Vanguard bond funds (1-800-662-7447). They have the lowest annual charges around and do a good job with their bond funds. There you can invest a much smaller amount, like $2,000, and pay low management fees, like 0.2%.

However, you no longer have a set maturity date, so you want to limit your investments to short-term funds like their Short-Term Corporate Fund. That fund has an average rating of A1, an average maturity of 2.7 years, an average yield to maturity of 4.0%, and a current yield of 4.31%, as of November 12, 2002.

Another option is their Ginnie Mae Bond Fund of all government mortgage debt, with a AAA rating, average maturity of 2.7 years, average yield to maturity of 4.1%, and a current yield of 5.2%.

Posted November 18, 2002