Conservative investors are becoming tangled in the lifeline the Federal Reserve threw to the economy last week.
To try to prevent a serious recession, Fed policymakers have been cutting interest rates. The goal is to make it easier for businesses and consumers to borrow money so they will spend and help businesses profit, keeping employees in their jobs.
But investors - especially retirees - who count on safe U.S. government bonds for income are not finding the cuts comforting. Interest on the safest bonds has been shrinking since the Fed started lowering rates in the fall.
About seven months ago, investors who bought a U.S. Treasury bond maturing in 10 years could count on a 5 percent yield. If they want to buy a 10-year Treasury now, the yield is about 3.6 percent.
Financial advisers are fielding calls from individuals hoping to find a magic investment - the dream combination of low risk and a high yield, or interest rate. Unfortunately, no such fix exists.
"People who reach for yield are reaching for risk," warns Harold R. Evensky, a financial adviser with Evensky & Katz in Coral Gables, Fla. "As long as they are getting the higher yield they will feel good, but feeling good doesn't mean that they will remain safe and continue to feel good."
To understand the risks in reaching for yield, investors need look no further than the current economic troubles.
Financial institutions are suffering to a large extent because they ignored risks in the mortgage market over the last few years. Many naively bought bonds involving mortgage payments because those bonds were supposed to pay a little more interest than safer bonds. Now, the dangers in the mortgage-related bonds have become clear.
As people have failed to make mortgage payments, the bonds that relied on timely payments have become virtually worthless. And financial institutions that invested in the bonds have lost billions.
Because those institutions now need to raise money to make up for the losses, they are selling preferred stock.
For the investor who has seriously contemplated the risks, and has a well-diversified portfolio of bonds, the preferred stock could be worth the risk, said Marilyn Cohen, chief executive of Envision Capital Management in Los Angeles.
But Evensky notes that diversified means several bonds in a $1 million portfolio - and not a bet on a handful of high-risk investments.
The attraction, Cohen said, are the 8 percent yields - the price troubled financial institutions must pay to persuade investors to take a chance on firms regularly reporting billion-dollar disasters over the last couple of months.
Typically, preferred stock would be yielding only about 2 percentage points higher than U.S. Treasury bonds, said John Miller, manager of the Nuveen Preferred Securities Fund.
Investors sensitive to risk, he said, might do better investing in monopolistic electric utilities or municipal bonds.
He says munis are cheap now because Wall Street firms, forced to sell securities quickly to raise funds, unloaded solid bonds. Also, the municipal bonds have been hurt by concerns that insurance firms such as Ambac and MBIA were so injured by insuring mortgage-related bonds that they could fail to provide adequate coverage.
Even without insurance, however, Miller said some municipal bonds are solid, with backing from state or local governments.
The safest would be "general obligation" bonds, where the government promises to pay bondholders even if a project doesn't meet expectations.
In the current environment, advisers such as Evensky said they want to stick with the highest-quality corporate and municipal bonds - those rated AAA or AA.
"AAA corporate bonds may not look very sexy," said Thomas Ricketts, chief executive of Chicago bond firm Incapital. For example, an AAA-rated GE Capital bond that matures in 12 years sells with a coupon of 5 percent. "But on a percentage basis, it's 150 basis points [1.5 percentage points] above Treasuries, and the company has a real solid balance sheet."
In addition, investors can still take advantage of relatively high interest rates on certificates of deposit. The average two-year CD recently was yielding 4.95 percent, according to Bankrate.com.
The yields on CDs have not dropped as much as U.S. Treasury bonds because financially stressed lenders have been offering high rates to attract nervous investors.
Although some of these institutions continue to be tarnished by the mortgage mess, investors are safe in those covered by FDIC insurance. The Federal Deposit Insurance Corp. covers accounts up to $100,000.
Gail MarksJarvis writes for the Chicago Tribune.