Friday, August 17, 2007

Interest Rate Risk and the Saver

For the saver, it is easy to misunderstand interest rate risk and its impact on our strategies. For the purposes of this discussion, I will focus on saving strategies designed to provide access to cash in an emergency and will ignore credit risk by focusing on insured accounts or government securities.

Bond prices are irrelevant to savers, but interest rate fluctuations are not.
• Because bond prices are inversely related to interest rates, bond prices will fluctuate as interest rates change.
• For savers, the bond prices are irrelevant because we can hold securities to maturity.
• BUT – we cannot escape interest rate risk. Although we will get 100% of the security value at maturity, we “lose” interest while our money is locked up.

Example: Bob buys a $10,000 CD from his bank with a 1 year maturity. Based upon current interest rates, Bob will receive 10,675 at maturity. Bob is happy.
• After 6 months, interest rates spike upward. Although Bob will still get his $10,675 back, he has “lost” money with his CD.
• Because Bob cannot reinvest his money at the higher rates for 6 months, Bob has become a victim of interest rate risk.
• Of course, Bob is a winner when interest rates fall (the Fed cut rates today) because he is getting more interest then the market is currently paying.

The Risk Premium: To compensate the saver, Banks and other borrowers must pay savers a premium for tying up their money in longer term interests (CD’s, T-Bills, Bonds)

Recommendations for Savers:

1. First in – the emergency fund should be invested in a high-yield “cash” investment with little or no investment risk. I have a two-tier strategy for this money. My one month emergency fund is in a high-yield savings account with ING Direct. Easily tied to my Electric Orange checking account, I can get to this money almost instantly if needed. Although ING doesn’t pay the best rates anymore, their service is first rate and the convenience/speed saves me the cost of having to keep any money on my credit cards (I pay in full each month). The second tier of my savings strategy is a high-yield money market mutual fund through Vanguard. In addition to the slightly higher rates, it takes 2-4 days to get the money out. This prevents me from spending my savings.

2. Time Money – After the emergency fund, I have a 2 year ladder of CD’s maturing at different times. This allows me to get paid the risk premium for tying up my money for 2 years at a time. By laddering the CD’s, I get paid the prevailing rate on new investments as the CD’s mature and get reinvested.

3. Treasure Bills – TreasuryDirect allows savers to structure a ladder of T-bills with no transaction costs. A good option; however, I prefer the convenience of CD’s.

Convenience Premium: Unless you are the Bank of New York, you are unlikely to have enough money in “cash” to make a huge difference in your finances. While the money is nice, one shouldn’t spend thousands of dollars of time chasing hundreds of dollars of interest. Find a good bank or banks, enjoy the interest, and your free time.

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