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Investing in a low interest rate environment

What is going on with the economic recovery? The economic news is suggesting the recovery may be slowing down. While the recovery appears real, there also appears to be a moderation in the pace of recovery. This may offer a reason why Dr. Greenspan counseled Congress earlier this week that the Fed was in no hurry to raise interest rates. He is concerned that the economic recovery needs to gain more strength before taking away the very low interest rates and monetary stimulus. This isn’t a surprise as Dr. Greenspan hasn’t acted to raise rates within six months of an economic cycle bottom during prior cycles where he chaired the FOMC.
    The wall of worry still remains. Many people have built up substantial reserve positions and now appear to be under-invested in equities given, their current investment objectives and risk tolerances. This behavior on the part of retail investors is very typical during the early part of a new bull market. It will probably take a market move above 12,000 on the Dow before reluctant retail investors return to the market place. They aren’t alone; there doesn’t seem to be any substantial draw down of institutional cash reserves even though all the market averages are up at least 20% from their September 21, 2001 lows and it has been more than six months since any major average has hit a new 52-week low. Several mutual fund families still hold near-record cash holdings. Remember, we are in the early stage of a bull market; we are in the early stage of an economic recovery; major economic forces continue to emerge in healthcare, technology and financial services that should be able to drive substantial new economic growth over the next three to five years and interest rates are below the inflation rate. These are all bullish signs for stocks over the next six months. The current rally has plenty of time to mature before it attracts exuberant speculators that typically mark the end of a major market rally.
    Several investors are concerned with the very low interest rate environment. As CDs mature they cannot be replaced at comparable rates. It can pay to invest in a diversified fixed income strategy. There are many ways to create diversity in your portfolio. Varying maturity dates can create a higher rate of return and still allow access to the principal in incremental amounts. Diversifying your portfolio with a mix of treasury and agency securities, corporate and municipal bonds, certificates of deposit, and cash for special needs can also increase your returns. It is important to analyze your risk tolerance when deciding upon your investment choices.
    When choosing investments, many individuals look for predictable income, low risk and preservation of capital. Some of the most popular fixed income investments are U.S. Treasury securities, which provide the highest degree of safety, and federal agency securities – debt instruments issued by an agency of the United States government - which also carry a very high credit quality, most being AAA rated. Some agency securities are backed by the full faith and credit of the United States; others, referred to as government sponsored enterprises, are obligations of the issuer. They are available in short, intermediate and long-term maturities. Some government agency securities are exempt from state income tax.
    Municipal bonds, commonly called munis or tax-exempts, are issued by states, cities, towns, school districts and public authorities. The funds raised by municipals usually support the construction of public projects, such as hospitals and highways. In general, municipal bonds pay interest that is exempt from federal income taxes. Some municipal bonds are also exempt from state and local taxes. The advantage of tax exempt is simple; for every dollar you earn you get to keep all of it. If you have a taxable certificate of deposit or bond you generally must pay income tax on the earnings, depending upon your taxable income. As an example, if you are in the 28% federal tax bracket and 8% state tax bracket. for every $1.00 you earn you would pay .36 cents in income tax leaving a .64 cent return on your investment.
    Corporate bonds are issued by organizations in order to raise capital. Most bonds pay fixed interest semi-annually and have a predetermined maturity. Bonds offer varying degrees of safety and risk depending on corporate strength and security. They do take precedence over preferred and common stock. Three major research companies rate the quality of bonds, based on the financial stability of the issuer. Financial analysts do extensive research to inform investors of an issuer’s ability to meet the scheduled interest payments and to repay the principal at maturity.
    Certificates of Deposit (CDs) are offered by a variety of financial institutions. CDs have a variety of maturities ranging from three months to ten years. Brokerage firms offer brokered certificates of deposit from different financial institutions based upon rates of return set by issuers. An issuer’s safety record and standards should be considered. Generally, CDs are insured by the Federal Deposit Insurance Fund (FDIC) for banks and Savings Association Insurance Fund (SAIF) for savings associations.
    Every individual has different investment objectives and risk tolerances. Take the time to create your own investment strategy to make your money grow. 
    Nancy Hadley is an Investment Representative with D.A. Davidson in Sandpoint.

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Nancy Hadley

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