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Investing in a Low Interest Rate Environment

Low interest rates create a dilemma. Do you accept a low return because you feel you must protect your principal? Or do you take on greater investment risk in order to try for a higher return? Here are some factors to consider in trying to balance those two concerns.

Consider laddering CDs

When yields on Treasury bonds began dropping, many investors were attracted to bank certificates of deposit (CDs). However, interest rates won't stay low forever; at some point you may want access to your money before a CD matures. One way to potentially achieve higher rates while retaining some flexibility is to ladder CDs. Laddering involves investing in CDs with varying maturity dates. As the shorter-term CDs mature, the proceeds can be reinvested in one with a longer term, which may have a higher rate. Over time, laddering may provide both the higher rates typically offered by longer-term CDs, and the ability to adjust as rates change.

For example, let's say Harriet Hypothetical wants to invest $60,000 in CDs. She might put $20,000 in a one-year CD that pays 0.5%, another $20,000 in a three-year CD that pays 1.25%, and the final $20,000 in a five-year CD that pays 1.75%. When the one-year CD matures, she reinvests that money in another five-year CD. When her three-year CD matures, she reinvests it in still another five-year CD. At that point, funds from a maturing CD will be available every year or two, but will earn the higher five-year rate. If rates are lower when a CD matures, she has the option of investing elsewhere.

Pay attention to costs

Low returns magnify the impact of high investing expenses and taxes. Let's say a mutual fund has an expense ratio of 1.00, meaning that 1% of its net asset value each year is used to pay operating expenses such as management and marketing fees. That 1% represents a much bigger bite out of your return when the fund is earning 3% than it does if a fund is earning 10%. At the higher number, you're losing only about 10% of your return; at 3%, almost a third of your return goes to expenses. If you prefer individual stocks, keep an eye on trading costs.

Before investing in a mutual fund, carefully consider its fees and expenses as well as its investment objective and risks, which can be found in the prospectus available from the fund. Read the prospectus carefully before investing.

Think about your real return

Low interest rates may not be quite as problematic as they seem. Even if you're earning a low interest rate, your real return might not suffer too much if inflation is also low. Real return represents what your money earns once inflation is taken into account. With an annual inflation rate of 2.6%--the average over the past 20 years based on the Consumer Price Index--a bond that pays 3.5% would produce the same real return as a bond that pays 4.5% when inflation is 3.6% a year.

Compare interest rate and yield spreads

In general, long-term bonds pay a higher interest rate than bonds with a shorter term. However, the difference between long-term and short-term rates can change as investors assess changing economic conditions. For example, when it seems likely that interest rates will rise in the near future, investors often are reluctant to tie up their money in longer-dated maturities and gravitate to short-term debt. As short-term demand rises, the difference between the interest rates paid by different maturities can also increase.

The yields of various types of bonds can also change relative to one another. For example, when demand pushed U.S. Treasury yields to new lows in 2011, it widened the gap between Treasuries and corporate bonds. Such differences can create opportunities in one type of bond versus another.

Consider small changes

Your portfolio may not need a complete remake to seek a higher return. For example, if you're in Treasuries, you could move a portion of that money to municipal bonds. That might involve greater risk of default, but net returns might be boosted by the munis' exemption from federal income tax. Or a portion of your stock allocation could be shifted to dividend-oriented stocks, exchange-traded funds, or preferred stock.

Look for buying or selling opportunities

Interest rates also can be used to help evaluate equities. Some analysts like to determine the relative value of the stock market using the so-called Fed market valuation model. (Though not officially endorsed by the Federal Reserve Board, the method seems to have evolved based on a 1997 Fed report.) The model compares the earnings yield on the S&P 500 to the 10-year Treasury bond's yield. If the S&P's yield is higher, the market is considered undervalued. However, this is only one of many valuation models and shouldn't be the sole factor in an investing decision.