Rising Rates and Bond Funds – Consider These Alternatives

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By Ken Nuss

Bond funds – including mutual funds and exchange-traded funds (ETFs) – are popular because they have attractive characteristics. But they have significant drawbacks.

Ken Nuss

Bond funds are liquid and less volatile than stock funds, and they generally pay monthly income. They come in many forms, from lower-risk offerings like short-term US Treasury funds to riskier investments like junk bond funds that offer higher rates and potentially higher returns. Municipal bond funds pay interest free of federal income tax and sometimes state tax.

But there is a big drawback. When interest rates rise, bond fund stock prices fall because lower-yielding bonds will be worth less. In 2021, Morningstar’s core bond index fell 1.61% while its US government bond index fell 2.28%.

One way to reduce volatility is to invest in bond funds with shorter maturities. They hold their value better than longer-term funds when rates rise, but short-term funds today offer very modest returns.

Although bond funds are not as volatile as equity funds, nevertheless, even modest declines can be disconcerting to investors who look to them for stability. And interest rates are likely to continue to rise in 2022. The Federal Reserve Chairman has promised to raise rates more than once this year to fight inflation.

What are the alternatives for investors and savers who wish to protect their money from risk, obtain a competitive interest rate and ensure that their capital is guaranteed?

Safe alternatives: bank CDs and fixed annuities

One choice is a certificate of deposit. Offered by banks and credit unions, CDs offer rock-solid security as they are federally insured for up to $250,000 per bank, per person. If you have more money to invest than that, you can get full protection by spreading your CD money among multiple banks. Terms ranging from a few months to 10 years are available.

But the price of security is high: current rates are very low. As of February 1, 2022, for example, the highest rate for a three-year CD was just 1.10%, according to Nerdwallet.

Deferred fixed annuities offer another route. They are said to be fixed because they guarantee your capital. They are distinct from income annuities, which guarantee the payment of current or future income.

When you save for retirement, you can build your savings faster because fixed annuities are tax-deferred and can pay more interest than CDs and most bond funds. Once retired, they can produce a secure and reliable income.

The tax deferral gives annuities a distinct advantage over CDs and bond funds (other than municipal bond funds). Interest is not taxed until you withdraw it from your annuity, and you can defer taxation of a non-qualified annuity indefinitely until death. At the end of the buy-back term of a fixed annuity, you can continue to keep your annuity with the same insurer and renew for another term. Or, if there is a better deal in the market, you can transfer the proceeds to an annuity issued by another insurance company through a tax-free 1035 exchange.

Deferred annuities are not for everyone. If you withdraw money from an annuity before age 59½, you will pay a 10% IRS penalty on the interest you receive in addition to federal and state income taxes. . (The IRS will waive the penalty if you are permanently disabled.) So only people who are already 59½ or are sure they won’t need the money before that age should buy an annuity. In addition, you could be penalized by the insurer if you make excessive withdrawals before the end of the redemption term.

Additionally, annuities are not FDIC insured. However, they are guaranteed by the issuing insurance company. As a safeguard, state guarantee associations are required by state law to cover fixed annuity owners in the event of an insurer default. Coverage limits vary by state.


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Fixed rate and fixed index annuities

There are two popular types of fixed deferred annuities: fixed rate annuities and fixed indexing annuities.

Fixed rate annuities that offer a multi-year rate guarantee behave much like a CD, paying a fixed, guaranteed rate of interest for a set period of time. When you buy one, you transfer the risk of rising interest rates to the insurance company. Terms of two to ten years are available.

Fares have increased a bit in 2022 so far. Starting in early February, you could get up to 2.55% for a three-year term and up to 3.15% for a five-year annuity, for example.

Fixed index annuities offer another approach for people who don’t mind getting an interest rate that fluctuates each year. When the stock market goes up during the year, you will get a share of the gain in the form of interest credit. Due to different caps and participation rates, you may only get a portion of the annual market gain as measured by an index such as the Dow Jones Industrial Average or the S&P 500.

If the market index is negative for the year, you generally won’t get any interest, but you won’t lose anything. Due to this fluctuation, these products are generally not suitable for people who need a current income to cover their living expenses. Instead, they work best as long-term instruments that allow you to build wealth for retirement through tax deferral while eliminating the risk of losing money or sleeping when the stock market goes down. collapses, as it does periodically.

The downside is that if the stock market continues to rip for several years, you will only get a portion of the gains. But for many investors who are risk averse but still want growth, it’s a trade-off they’re willing to make. The key is to understand the limits of the upside and downside protections so you can choose the one you are most comfortable with.

About the Author: Ken Nuss

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed rate, indexed and lifetime income annuities. He is a nationally recognized annuity expert and author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.

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