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How to find the best fixed-income investments

January 15, 2010

For the last year or two, looking for good, secure fixed-income investments has been a little like playing a game of Whac-a-Mole. Every time you find a good investment idea, the next time around it seems like you need to look in another hole.

The joke among my financial planner colleagues is that never has so much effort been expended for a measly half-percent yield. Fifty basis points is nothing to sneeze at, though, meaning an extra $5,000 a year on a $1 million fixed income portfolio.

Many of us may prefer thinking about the upside of equities, but with a little effort you can also increase returns in fixed income.

Fixed-income investments are used to help us sleep at night and keep our hands off the more volatile (and potentially higher earning) equities. Even those investors who scoffed at risk tolerance questionnaires and pounded their chests on their appetite for aggressive investments were often reduced to a wide-eyed panic as financial Armageddon closed in a year ago.

Fixed income investments enabled my clients to keep their hands off the switch in those dark days and avoid the atavistic urge to sell, sell, sell. Here are some fixed-income options you may not have considered:

Negotiable CDs. FDIC-guaranteed certificates of deposit are available at local institutions, but the rates can be relatively anemic at about 1.25 percent with a local five-year CD. Negotiable CDs are also offered by banks around the country, but are traded on the market like bonds and are available through online and traditional brokerage firms.

Just like the CDs at the bank around the corner, most of them are guaranteed by the FDIC up to $250,000 through the end of 2013.

You can either purchase new issues at face value without a commission or secondary offerings for a modest transaction fee. So how much better can we do than 1.25 percent? There are FDIC-guaranteed five-year CDs currently available that pay a 3.3 percent yield to maturity -- a striking difference.

Unlike traditional CDs, there is no penalty for early withdrawal with negotiable CDs. However, you can lose principal if you decide to sell them before maturity.

Also, take care that you don't invest in some of their more complex brethren -- callable CDs, stepped coupons or indexed CDs -- without understanding the risks. Just like your local institution, it pays to know the financial health of the bank standing behind the negotiable CD through Web sites such as bankrate.com.

Even though you're protected by the FDIC, you don't want to get your principal back two years into a five-year CD if interest rates happen to be in a swoon.

Treasury Notes and STRIPS. In an interesting flip, for the past few months Treasury Notes and STRIPS are now beating the yields of most CDs. That's true even without considering the advantage of Treasury income being free from state income taxation. Five-year Treasury Notes pay 2.11 percent annually at this time, beating the locally available CD mentioned earlier by almost 1 percent.

Treasury STRIPS, like Notes, are guaranteed by the full faith and credit of the U.S. government. However, they do not generate interest every six months, but instead pay all accrued interest at maturity. They're perfect for bond ladders with their predictable income streams in future years.

If you're in an upper income tax bracket, watch out the "phantom income" of STRIPS that is taxed even though the investor must wait until maturity to receive it. That's why tax-deferred accounts such as IRAs are the best place to hold STRIPS. Notes are available from treasurydirect.gov or your broker or financial planner, who can offer Treasury STRIPS as well.

So you can see with a little diligence, you or your adviser can discover a gift this holiday season -- additional income without additional risk.

Dave Gardner is a certified financial planner with a practice in Boulder. He can be reached through his Web site at yellowstonefinancial.com.

Dave Gardner