Returns on fixed-income investments depend on their risk level

Q: My checking accounts pay next to nothing in interest, and even most certificates of deposit are paying barely more than 1%. Yet I see advertisements offering much higher returns on various investments. How is that possible?

A: The important thing to remember regarding fixed-income investments is the relationship between risk and return. Basically, a higher interest rate on your investment means you are taking greater risk. You may not always see the risks clearly, but they exist. Among them:

The borrower. A U.S. Treasury investment, such as a treasury bill, almost certainly will return the promised interest and principal to you. A corporate bond generally is riskier, however, and thus should pay you a higher rate of interest. Bonds from unrated companies, foreign companies, and even some foreign governments may carry risks that are difficult to identify or quantify, however, so be extremely cautious when considering them as an investment.

Moreover, if prevailing interest rates increase because of the higher inflation (as usually happens), the value of your bond when you sell it will be reduced. In other words, you should be compensated, in the form of a higher rate of return, on any fixed-income investment that lasts more than a couple of years.

Bank failure. The Federal Deposit Insurance Corp. guarantees deposits in commercial banks only up to $250,000 if your bank fails. Having any more than that at the bank makes you, in effect, the bank's general creditor. It's not worth the risk for a 1% return on a certificate of deposit, is it?

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Podnos is principal of WealthCare LLC in Merritt Island, Florida. The information in his answer is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. Send your money management questions to medec@advanstar.com Also engage at http://www.twitter.com/MedEconomics and http://www.facebook.com/MedicalEconomics.