How to 'lock in' on high interest rates
Many security advisers are recommending that investors "lock in" today's high interest rates. For instance, that's the advice of analysts with Merill Lynch, Pierce, Fenner & Smith Inc., the giant brokerage house.
"Moneywise" has discussed this "locking in" concept during the past few months. Reader feedback indicates some condusion about this practice, however. Buying utility stocks, for example, has been one method cited for locking in high yields. Here is how the idea works:
Suppose you have $20,000 in a money-market mutal fund. It may be paying 16 or 17 percnt interest annualized, but the rate changes daily. You have bought into a fixed-principal investment, as most money-market mutual funds maintain their share value at a constant $1 per share. Your $20,000 principal will never be worth a penny more. But your investment is earning variable interest, depending on daily changes in short-term interest rates. As interest rates drop , you will retain the $20,000 fixed principal but gain a succession of progressively lower yields -- supposedly into the single-digit interest levels that prevailed not so long ago.
One alternative for avoiding the expected decline in interest rates is to invest your $20,000 in the common stock of a well-managed utility. For example, consider a stock priced at $10 a share. Each share might pay $1.40 in dividends annually. Yield is easy to figure at 14 percent. Over a year's time you would gain $2,800 in dividend income. You can expect to receive the $2,800 each year independent of what happens to the price per share. Here you have a fixed return and the likely prospect of variable principal. Actually, many utilities increase their dividends by a few cents a year, but for this example, consider the $1.40 fixed.
Notice what happens when the general level of interest rates declines. In a typical knee-jerk reaction, prices for bonds and interest-sensitive stocks rise. If your stock was producing $1.40 a share when the general interest level was at 14 percent and the interest level declines to 12 percent, the $1.40 dividend means the stock is worth around $11.76 a share. Investors buy income and are willing to pay more for the $1.40 dividend when the general interest rate is 14 percent. Not only does the stock continue to earn $1.40 yearly at a locked-in rate, but your principal increases by 16.7 percent, in this example, if you should want or need to sell.
Obviously, the reverse can happen, as many investors already know. If investors paid $11.67 for the $1.40 dividend stock when the interest environment was 12 percent and interest rates rose to 14 percent, they saw the price of their stock decline -- possibly to $10 -- for a capital loss if they sold. "Locking in" a high interest rate may occur when prices for interest-sensitive stocks or bonds are at extrmely low levels. Astute investors recognize the inverse relationship between interest rates and prices of utility shares and bonds. Some believed they were buying in at the bottom when long-term interest rates were in the 14 percent range. The risk of unexpected price movements is always there. But the prospect for lower rates appears to be greater than for higher rates over the next two-year period.
The corollary to this strategy for holding on to or locking in high yields is to sell and take substantial capital gains when share prices reach their top later in the cycle.
Readers are invited to send questions to Moneywise, Box 102, Mercer Island, Wash. 98040. Only questions covering topics of general interest can be answered here, and no question can be individually acknowledged. Reference to specific stocks, funds, or other investments in this column are intended for the general information of readers and not as an endorsement of recommendation by The Christian Science Monitor.m