Sinking interest rates compel investors to abandon CDs for bonds, stocks

It's taken a while, but more people finally seem ready to abandon the certificate of deposit ship. Cautiously, they're stepping into bonds and bond funds. Others, however, may be jumping into potentially dangerous territory in the quest for higher yields by going directly into stocks and stock mutual funds, following the publicity about last year's performance for these investments.

A woman who called last week illustrates where many people are with their money today. The woman, in her 70s, has almost all her savings, about $40,000, in a small-town bank CD. The bank is about to roll her nest egg into a new CD with a 3 1/2 percent yield, so her first thought was to move the money to another bank in a large city where it could earn more. But since 4 or 4 1/2 percent still won't meet her income needs, the woman realizes she has to look for something else.


Like many people, it's taken rates this low to make her consider options she should have been using a long time ago.

While yields in the bond market have also been falling, good alternatives to CDs exist, if people understand the instruments and the risks.


"People are beginning to understand that the value of their money is being eroded by inflation," says Charles Wallis, president of Back Bay Advisers, a unit of New England Investment Companies in Boston. Even though the consumer price index rose just 3.1 percent last year, many people, especially retirees, experienced higher inflation than that.

Recapturing the 7 percent to 9 percent CD yields of a year or so ago is "sort of like the search for eternal youth," says Geoffrey Hyde, senior vice president at Alliance Capital Management in New York.

Eternal youth is not available yet, but higher yields are. However, if interest rates start to go up again, the prices of bonds and bond mutual funds could fall substantially and losses could more than offset any gains from higher interest rates.

For many people, the first step out of a money market fund or CD is a short-term bond fund. In response to investors' demands for higher returns, several mutual fund companies have created or improved these products, buying higher-quality corporate bonds and shorter-maturity issues so they aren't locked into a low yield if rates go up.

At Scudder Stevens & Clark in Boston, for instance, the Scudder Short Term Bond fund (800-225-2470) has taken in more money than any other product the company offers. It is paying a yield of 8.12 percent, Scudder spokesman James Smith says.

Another alternative, the Scudder Medium Term Tax-Free Fund, has a yield of 5.85 percent, but since its income is free of federal taxes, that's equivalent to a taxable investment earning 8.15 percent for someone in the 28 percent tax bracket.

Normally, investors who want tax-free money market funds expect to get a yield that's about a percentage point or so less than they could get from a regular money fund, but the tax-equivalent yield is usually about the same. That isn't the case now. Scudder's Tax-Free Money fund is paying a tax-equivalent yield of 4.07 percent, or almost a full percentage point less than several money market funds.

Yields on bonds and bond funds differ importantly from CDs in a way some people forget, investment advisers say. With a CD you get the stated yield for the full term. If you have a one-year CD with a rate of 5 percent, that's what you get for the year. With a bond fund, the yield can change any time. And while the yield doesn't change on a bond (assuming it doesn't default), if you need to sell the bond before it matures, you might get back less principal if interest rates have gone up.


One of the newest products designed to answer the demand for higher yields is the ARM fund. These funds, which primarily invest in pools of government-backed adjustable-rate mortgages, are paying yields of about 7 1/2 percent.

So far only a few mutual fund companies have introduced ARM funds, including T. Rowe Price and Benham, which are no-load funds and can be purchased directly from the companies without a sales charge, and New England Securities, Putnam, Franklin and Keystone, which are all load funds, sold by brokers or financial advisers. ARM funds have their risks, too. If interest rates rise suddenly, an environment that the new ARM funds haven't seen, their net asset values would fall, meaning a loss of principal for people who need immediate cash.

Also, ARM funds could decline in value if many homeowners decide to refinance out of adjustable-rate mortgages into fixed-rate loans now that rates on 30-year fixed mortgages are around 8 percent. Even though this might be slightly more than homeowners are paying on their ARMs now, being able to lock in a low 30-year rate may be too attractive to pass up.

People who want a more conservative element in their bond portfolio might consider a fund that invests in securities from the U.S. Treasury and government-backed agencies. The yields are lower, but the comfort level may be higher.

For example, the Neuberger & Berman Limited Maturity Bond fund (800-225-1596) is paying a 5.78 percent yield, says Didi Weinblatt, a portfolio manager. The fund has put 43 percent of its assets in intermediate-term treasuries that mature in about three years, 25 percent in government-backed agencies, 9 percent in high-grade corporate bonds and 3 percent in ARMs, Ms. Weinblatt says.

U.S. government securities are also part of a fairly new fund offered by Colonial Investment Services in Boston. About 30 percent of the firm's Strategic Income Fund (800-426-3750) is invested in government securities, portfolio manager Carl Ericson says. But to increase diversification and yield, the fund also buys high-yield corporate and foreign bonds, Mr. Ericson says.