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How to Survive When Rates Fall

Ever since mortgage problems started working their way into the markets in July, stock investors have looked to the Federal Reserve to prevent big drops by cutting interest rates. Yet while the stock market has thus far limited its losses to a 10% correction, those who depend on regular income from bonds and CDs are feeling the pinch.

In response to previous rate cuts, and in anticipation of further ones, the bond market has seen rates fall through the floor. Rates on Treasuries are hovering around 3% on maturities as long as three years, and even the 10-year note recently fell below 4% for the first time since 2005. Rates on shorter-term bonds are down a full 2%. When you consider that going from 5% to 3% means losing 40% of your income, you can understand why retirees and others on a fixed income are hurting.

Filtering through
Lower Treasury rates haven't yet had such a large impact on the CD market. According to Bankrate, average rates on one-year CDs have fallen about half a percent so far. Even banks with a strong desire to raise cash are starting to lower their rates. Countrywide (NYSE: CFC  ) has dropped its one-year rate to 5.05%, and E*Trade (Nasdaq: ETFC  ) is at a 5.15% APY. Those rates are likely to fall further as the credit markets readjust to new economic conditions.

So what can savers do to try to preserve their income? The key lies in a simple concept: diversification. By diversifying your savings in a number of different ways, you can reduce the degree to which lower rates affect you. Here are a few ways to protect your portfolio:

  • Going long. Over the last year or so, the inverted yield curve meant that savers weren't immediately rewarded for buying longer-term investments. However, those who did still got a benefit that's now more evident: locking in a relatively good rate before rates started to fall. Even as CD rates have turned upside-down as well -- longer-term CDs aren't yielding any more, and at many banks yield less, than short-term CDs -- buying a few CDs with long maturities can help insulate your cash flow from falling rates.

  • Consider corporates and munis. Alternatives to Treasuries and CDs aren't as safe, but they can improve your returns. Municipal bond rates are sometimes higher than comparable Treasuries, even before you consider that they're free from federal income tax. Investment-grade corporate bonds are yielding 1%-1.5% more than Treasuries of the same maturity.

  • Dividends are income, too. In the past, declining rates have often brought on stock-market rallies. Having some dividend-paying stocks in your portfolio can give you both stable income and a chance at some price appreciation. And while high-yielding financials like Citigroup (NYSE: C  ) and Washington Mutual (NYSE: WM  ) are reeling from mortgage losses, you can find high dividends from companies in other industries, such as utility Duke Energy (NYSE: DUK  ) and tobacco-maker Altria (NYSE: MO  ) .

If rates continue to fall, it's possible we could see a return to conditions from earlier this decade, where CDs paid rates of 2.5% and less. If you do nothing, you could see your income cut in half. But taking steps now to protect yourself from that possibility will pay big dividends in the long run.

You can learn more about saving by reading about:

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