Ways Fixed-Income Investors Can Avoid Bad Outcomes

Introduction:

Blind trust that your financial advisor and the financial institution that manages your money will do the right thing for you financially can be very costly.

Banks, while often essential for paying bills and getting cash for expenses, are no longer central to the personal finances of most households.  Many banks will roll over a high-cost CD to an instrument with a subpar interest rate. 

Banks solicit deposits for their own use and do not provide much guidance on alternative fixed-income investments.

On-line brokerage firms provide a better snapshot on investment opportunities and interest rates than banks.  However, brokerage firms tend to steer their customers to bond ETFS created by the firm.  Investors lose substantial money in these products when inflation and interest rates are rising.

On-line brokerage firms do offer direct investments in Treasury bonds.  However, small investors often cannot purchase bonds on on-line brokerage portals because of the minimum purchase requirement.  Financial advisors often neglect to tell their clients that the minimum purchase requirement for any Treasury bond at Treasury Direct is only $100. 

Series I Savings bonds, which are only available directly through the Treasury, are the best possible hedge against inflation.  Most financial advisors neglect to mention this important asset.

This post examines steps fixed-income investors must take to their financial outcomes.  These decisions include:

·      No longer automatically rollover CDs without approving the future interest rate.

·      Move funds out of institutions that automatically reinvest funds at sub-market interest rates.

·      Reduce the use of bond ETFs, with no maturity dates, especially when interest rates are low.

·      Expand utilization of short-term bond/CD ladders with multiple maturity dates.

·      Small investors impacted by minimum purchase requirements should purchase some bonds through Treasury Direct.

·      Increase the utilization of Series I Savings bonds, again through Treasury Direct.

Analysis of these point is below:

Issues with automatic rollover of CDs

A recent Wall Street Journal article documented the tendency for some banks to automatically roll over existing CDS to new CDs with extremely low rates.

The article starts with an example of a person with an old $50,000 CD at a 3.85 percent interest rate, which renewed at a 0.05 percentage rate.   The monthly interest earned from the CD investment went from $160 to $2.15.

Banks are required to send a notice to customers that a CD will roll over but are not required to include information about the new rate in the notice.

Many people are busy, and it is likely that a substantial number of investors fail to roll over CDs at market rates.

This post considers steps that savers should take to prevent the automatic purchase of CDs with interest rates below the market rate and how to respond if their bank does roll over your money to a low-rate asset.

There is something unethical about a bank, especially one with a wealth management service actively offering financial advice to customers, steering customers to a zero-rate return while offering generous rates to new customers.  The bank mentioned in the Wall Street Journal article, U.S. Bank, has a wealth management group.

An appropriate way to respond to this type of situation is to take all your money at of the bank and put it into another institution.   I did close a Wells Fargo account a few years ago in response to their scandal.  

A less disruptive immediate response is to close the CD and move the money to another institution. 

The withdrawal from the CD is likely to come with a penalty, which as discussed in this Investopedia article comes with a penalty.  Penalties could be three months interest for a short-term CD and up to 12 months interest for a long-term CD.

The potential good news here is the penalty is low if it is based on interest earned on the current CD.

The investor can explore options at a brokerage house or open an account at Treasury Direct and use a checking account at the bank for the source of purchases of bonds at Treasury Direct.

Issues with fixed-income investments at brokerage firms:

Brokerage firms do a much better job at providing their clients a range of investment options.

The bond/CD portal at the brokerage houses allow investors to quickly look at a range of products and rates in the market and to purchase with a couple of clicks. 

By contrast, the customer at a bank is not usually offered Treasury bonds and is only offered the CD at the bank, not its competitors.

Some brokerage firm CD/Bond portals allow for the investor to automatically reinvest the CD.  Be sure to click NO on this option to avoid the possibility of signing up for a low-rate product.

Most financial advisors at brokerage accounts, like their peers at banks, are likely to push products that help their firm instead of products that help their clients. 

Financial advisors at brokerage firms routinely advocate for the purchase of bond ETFs.

This Vanguard article argues for the use of bond ETFs during periods of high inflation.

These bond funds often perform poorly in periods of inflation and higher rates.  Here are three examples.  

·      The risk of bond funds is greatest when the bond fund includes long maturity securities.

·      Even short-term ETFS and ETFS with inflation linked securities in their name tend to lose money when inflation and rates rise.

I was amazed that financial advisors continued to push investments in bond ETFs sponsored by their employer when interest rates fell during the pandemic.  At that time interest rates had only one direction to go and losses were inevitable and immediate.

Losses can be avoided by purchasing short-maturity Treasury securities and holding them to maturity.

The regular planned maturity of securities provides investors with cash, which can be diverted to the purchase of stock once the Treasury bond or bill matures.

It is especially important to have cash in a scenario where geopolitical events or renewed inflation could push interest rates up and stock prices down.

This  Fidelity article  states correctly small investors often cannot purchase bonds at brokerage houses because of the minimum purchase requirement.

The article and many a financial advisor neglect to inform the reader or the client that the minimum purchase for any bond or note purchased through Treasury Direct is $100.

Small investors with limited cash should consider making all of their fixed-income investments at Treasury Direct.

However, Treasury Direct cannot be used investments inside an IRA or tax-deferred retirement account.  This lack of access to Treasury Direct and the minimum purchase requirements on Treasury securities does somewhat limit IRA investors at brokerage houses. 

·      IRA investors could still purchase bank CDs through the brokerage house inside the IRA.

·      IRA investors will be better off holding cash than bond funds when interest rates are low and rising.  (Perhaps 70 percent equity and 30 percent cash depending on the level of interest rates.)

Again, I am totally amazed that financial advisors continued to pitch a 60/40 bond portfolio during and after the pandemic when interest rates were extremely low.

Don’t be deceived into believing that an inflation-index ETF will do well in a period of inflation.

The Series I bond option:

Series I Savings Bonds should be included in every investor’s portfolio.  This asset purchased directly from the U.S. Treasury without fees is an effective hedge against inflation and higher interest rates.

Series I Savings Bonds can only be purchased through the U.S. Treasury and are not for sale at brokerage firms.  Private firms do not receive commission or fee income from their purchases.  Not surprisingly, most financial advisors do not aggressively tout the advantages of these assets.

A recent post looks at:

·      Key features of Series I Savings Bonds,

·      Reasons for purchasing Series I Savings Bonds

·      Differences between Series I Savings Bonds and Treasury Inflation Protected Securities (TIPS)

Concluding Thought: 

Many financial institutions – both banks and brokerage firms – hire financial advisors and have wealth management teams who claim to act in the interests of their clients.

The disturbing reality is many financial firms and advisors deliberately steer clients to suboptimal financial situations and away from products that reduce financial exposure and provide greater returns.

Your financial advisor is not your friend.