Fixed-income options worth a look

By Laura Bruce • Bankrate.com

Like a tuft of green grass that pops up in the bleak, brown yard after a long winter, fixed-income interest rates are showing signs of life. While borrowers fret about rising loan rates, folks who like to stash cash in certificates of deposit are enjoying the prospect of heftier income on their bank statements.

In a rising interest-rate environment, the name of the game is to stay flexible -- find the highest rate for the shortest term so you're not stuck when rates climb. Be sure you can move your investment to a higher rate if rates spike at your bank.

Current national averages, according to Bankrate.com, are 1.5 percent for a six-month CD and 2.10 percent for one-year. That compares with 0.92 percent and 1.04 percent, respectively, about a year ago. Of course, you needn't settle for average if you're lucky enough to have a bank in your neighborhood that's paying higher, or if you're willing to use a bank that's out of your area. Bankrate's highest yields page shows several institutions paying 2 percent or better on six-month CDs, and about a half-dozen offering 2.75 percent or better on one-year CDs.

Certified financial planner Ben Tobias of Tobias Financial Advisors in Plantation, Fla., isn't a fan of CDs at this time.

"I think we're going to be looking at significantly higher interest rates a year or two from now. We'll see a 25-basis-point increase every Fed meeting for the next six months. If you're locked into an interest rate, you're losing opportunity costs you might have had in a money market account."

CDs with a kick
But if CDs are a staple in your portfolio, one way to minimize potential losses is to purchase a bump-up or step-up CD, which allows you to move to a higher interest rate one time during the term. Be aware that some institutions pay a lower rate on bump-up CDs than they do on ones with comparable maturities that don't have the option.

Watermark Credit Union in Seattle, Wash., offers the bump-up option on all CDs with 12 months or less maturity.

"We're not trying to catch people with an option that they'll pay for later," says marketing director Jerry Sparrow. "They don't have to opt for this and give up a portion of the rate. They get the same great rate."

The best way to wait for the day when better rates prevail may be by opening a high-interest money market account. Just about everyone's seen the ads for ING Direct, always offering one of the top rates in this category. And there are other players such as Virtual Bank, which is paying 2.15 percent.

"We're opening thousands of accounts each month. Customers are looking for a convenient, easy-to-use, FDIC-insured account with a great rate," says Larry Fein, Virtual Bank marketing director.

"The question we hear is, 'How can you offer a rate like that when my local bank is offering a half percent?' We're an Internet bank and we don't have the overhead of a traditional bank, so we can offer the higher rate."

As with any financial account, be sure you understand what fees are associated with the account. Virtual Bank charges $50 if the account is closed in the first 90 days. Also, if you require a paper statement, there's a $5 monthly service fee.

Another online institution, Everbank, pledges that its money market account and high-yield CDs will always be in the top 5 percent of the national index as tracked by Bankrate.com.

"The guarantee provides our customers with a comfort level, knowing that they don't have to be looking over their shoulder all the time," says CEO Frank Trotter. "Can a local bank post a better rate? Sure, but it's probably not sustainable."

Inflation-proof income
If liquidity isn't a concern, consider securities that protect your principal from inflation.

If rates are rising, it's likely that inflation is playing a role in the process. Investing in inflation-protected instruments such as I-bonds or TIPS (Treasury Inflation-Protected Securities) will protect your initial investment by giving you a hedge against inflation, but the interest rate is usually set a little lower than corresponding Treasury-issued securities that don't provide the hedge.

TIPS can be purchased online directly from the government. Other options include inflation-protected bonds that are sold as mutual funds through brokerages such as Vanguard and Fidelity, or as an exchange-traded fund that trades like a stock on the New York Stock Exchange -- the symbol is TIP.

Another possibility is one that could provide a return considerably better than ordinary CDs if income isn't a concern, you can afford to lock up some cash for five years and you think the Dow Jones Industrial Average will rise over the next five years.

Indexed CDs
CDs that are pegged to stock market indices are sold through various brokers and banks. One example is a Dow-indexed CD that's available at some community banks. The CD is FDIC insured and sold in $1,000 increments. The term is five years and your principal is guaranteed if you hold until maturity.

Be sure to ask about the participation rate. That is the percentage of the return that you'll receive of, in this case, the Dow. Mike Sherzan, CEO at Bankers Financial Services, the company that sells this product to banks, says the participation rate for this Dow-indexed CD typically is 80 percent to 90 percent.

"So, the worst-case scenario is getting back 100 percent of your principal if you hold to maturity," Sherzan says. "If the Dow goes to zero, at least you'll get your principal back. The best case scenario is, at 80 percent participation rate, the highest return in five-year increments has been 17 percent on an annual basis. The average in that same period of time is 7 percent to 8 percent."

Even though you don't receive income from the CD during the term, you will have to pay taxes each year on a rate of return set by the IRS. If your final return is zero at the end of five years, you'll get a tax credit. If you have to cash the CD before maturity, expect a significant penalty.

As always, read the fine print before purchasing any investment -- even if it's just a plain vanilla CD.

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