Which of the following conditions will maximize the amount of interest you earn? This is a question we received last night during one of our weekly webinars. It is a very interesting question, and we are happy to continue answering these questions from customers and readers to everyone on our blog.
Getting any interest of any size these days is something that is very difficult. We are currently in an environment where almost half the world yields negative interest rates, with over two trillion dollars worldwide currently collecting negative interest. Wow.
There are two different conditions that we can point out that will help us answer the question to “which of the following conditions will maximize the amount of interest you earn?” in this short article. Buckle up as it will be fun!
What Two Factors Contribute to Higher Interest?
Economic potential and inflation expectations are clearly two ways that can impact that amount of interest one can get. But let’s assume for argument’s sake those are completely static. If this is the case, both economic growth potential and inflation expectations are not our two factors here.
In order to get higher rates of interest, there are two things investors can look at; risk and maturity.
The saying is true. The more risk we take, the more upside we can potentially make. In order to show this, let’s look at an example comparing United States interest rates vs Puerto Rican interest rates.
Right now for a 30 Year Treasury bond, an investor can receive 3.11% on their money each year over 30 years at a fixed rate. By comparison, an investor can get 9% on a 25 year Puerto Rican bond. So why the difference?
It’s all about supply and demand. The more demand there is, the more people buy bonds, the higher the price of the bond becomes, and the lower the yield is. More demand for a bond or fixed income means investors believe there is less default risk. These 30 Year US Treasury bonds are AAA rated, which is the highest rating a bond can get.
On the other hand, the 9% yield from the Puerto Rican bonds tells the market that there is far less demand. When there is less demand, investors buy less, prices go down, yields go up. Yields have to go up to start to create demand and give investors reasons to park their money. And not surprisingly, Puerto Rican bonds do not have an AAA rating.
Besides risk, maturity is the second factor for attaining the highest levels of interest. Let’s look at an example.
|US 10 Year Treasury Bond||2.50%|
|US 30 Year Treasury Bond||3.11%|
We can see that locking up your money for more time will yield higher interest. While this is not necessarily the greatest idea since in the example above you are parking your money for 20 additional years just to receive an extra 61 basis points a year. However, the question is “which of the following conditions will maximize the amount of interest you earn?”, and one of the ways to do that is to have further out maturity dates.
Which of the Following Conditions will Maximize the Amount of Interest you Earn? Risk and Maturity!
So there you have it, folks. Want to maximize the amount of interest you get? There are two ways to do it when investing in a fixed income product:
- Take more risk (more default risk)
- Extend duration
While either of those options might not be the best choice, they both give investors greater yield thus maximizing interest.