How to Earn Much More Interest on Your Investments

Finally, CD and money market rates are headed up again...or rather, they were. So far, the new millennium has not been too good to Certificate of Deposit investors. The Federal Reserve, trying to re-ignite and keep the economy going, cut interest rates repeatedly from 2000 into 2004. As a result, yields on bank deposits and CDs fell until the average rate for a six-month CD fell to 1.17% in 2003, according to the Federal Reserve.

Then, the economy rebounded, and the Federal Reserve, hoping to avoid overheating the economy, began raising interest rates. By the end of 2006, the average rate on the six-month CD had risen to 5.24%, and CD investors were beginning to cheer up. However, these days, CD investors aren't too happy. However, there are solutions for those seeking higher interest.

The Real Rate of Return on CDs:

While the national average is 4.36% for a one-year CD, that is not what investors actually receive. If you are in the 25% tax bracket, you'll only receive 3.27% after taxes. In addition, inflation is expected to average more than 3% in 2008. Therefore, you're real return after taxes and inflation is nearly 0% on a one-year CD. In this article, I will show interested investors how to earn a significantly higher real rate of return.

Given the devastating mortgage meltdown, it seems very likely that the Federal Reserve will be lowering interest rates even further in coming months. According to the December 17th issue of Barron's magazine, the consensus of market experts believe rates are headed significantly lower.

So what's an investor to do? Instead of settling for a rate of return of nearly 0% on CDs, consider these three higher interest rate alternatives. Before we get into the discussion though, remember to keep your emergency funds in a liquid account such as a money market fund. For your investment purposes however, the alternatives below may make a lot of sense.

Three Alternatives to Low-Rate CDs

1. Bond market exchange-traded funds (ETFs). ETFs can be purchased in almost any brokerage account, and give you instant access to a diversified portfolio of bonds. These bond ETFs come in many different forms and sizes. Some invest in the entire U.S. bond market. Others invest primarily in short-term Treasuries, or high or low-grade corporate bonds. Thankfully though, you do not need to tie up your money for years with any of these ETFs. They are totally liquid, meaning that you could sell them the day after you bought them, if necessary. The price may be higher or lower than you paid, however.

How much interest do they pay? That depends on the particular bond ETF in which you have invested. The total bond market ETFs are currently yielding as high as 5.28%. No investment is perfect for all investors, but bond ETFs can give you higher interest checks and greater liquidity than CDs.

2. Bond Closed-End Funds. One of the ways closed-end funds differ from ETFs is that they do not continuously offer new shares to the public. This means that instead of buying or selling shares directly from the investment management company, you buy or sell shares from other investors in the securities market place. This is very easy to do since each closed-end bond fund has its own symbol and trades much like a stock.

Some of these funds use leverage to enhance returns. This can result in even higher yields; however when bonds go down in value, these funds can lose more value than un-leveraged funds. For those who can handle the volatility, some closed-end bond funds are now paying 6% or more.

If the proper closed-end bond funds are selected, these investments also offer some capital appreciation potential for those interested in growth. One of the strategies I have used with my clients is buying closed-end bond funds at a discount to their net asset value (NAV). Our hope is that the market will realize the mispricing of the fund, and the share price will rise to equal the NAV. In situations when this has occurred, some of my clients have received 10% in share price appreciation in addition to a 6% dividend yield.

3. Municipal Bonds. For those in tax brackets of 25% or more, who are looking for investments outside of retirement accounts, it may make sense to consider municipal bonds. These are debt obligations of state and local governments and the interest payments are free from Federal taxation. At first glance, the yields may seem somewhat low, but remember, they are tax-free. This means that for someone in the 25% bracket a municipal bond paying 4% interest is equal to a CD paying at least 5.33%. In my financial planning practice, I had a client who had $50,000 invested in CDs paying 4% interest. This yielded $2,000 in interest before taxes, but just $1,440 after his tax bill. Upon maturity of the CDs, we invested the money in a municipal bond portfolio with an average yield of 4.6%. This solution increased his interest before taxes to $2,300, which is good but not spectacular. What was impressive however was the fact that all of it was his to keep. He netted almost $1,000 more in interest after taxes by using munis. Investors interested in this strategy can purchase bond ETFs or closed-end funds that invest in a diversified portfolio of municipal bonds.

We all know to diversify when building our stock portfolio, and it's just as crucial when building our bond portfolio. You should diversify across government and corporate debt, in varying maturities. This can pay big dividends in the long run. If done correctly, your bond ETF or closed-end portfolio could substantially increase the interest you earn. In addition, you could earn this higher rate of interest without having to worry about surrender charges.

The investments covered in this article are more complex than CDs, and they do offer the potential of significantly higher returns. If you have questions about whether they are appropriate for you, feel free to contact me at the email address below. I will try to answer as many questions from readers as I can.