The Fed Cuts Both Ways

By Bill Saporito

The fed bellied up to the bar last week and ordered a double. Greenspan & Co.'s decision to drop short-term interest rates by half a percentage point surprised Wall Street--which had expected a quarter-point cut--and brought rates to their lowest level in 41 years. That might help spur the economy by making it cheaper for businesses to borrow, but there's a downside. With inflation running at 1.8%, your bank savings or money-market fund yielding barely 1% is becoming a money loser. If you want safety with reasonable income, you'll have to get more creative.

The rate cut "doesn't create wealth," says party pooper Jay Mueller, economist at Strong Capital Management. "It transfers money from savers to borrowers," because debt gets cheaper and saving becomes almost a self-contradiction. If you got burned by stocks and, like many other people, have been hunkering down in cash or bonds, here are some things to know:

--Fortunately for savers, the situation is unlikely to get much worse, as the Fed has signaled that it is done dropping rates for now. For borrowers, things won't get much better for the same reason--there will be no Christmas rate cut.

--If the economy rebounds, many types of bonds will become riskier, if only because when rates inevitably head back up, the value of today's low-yielding bonds will fall. (It's that old formula: rates up, bonds down.) The parallels between today and 1993-94 may be instructive. Back then, a slow, jobless recovery and falling rates prompted many people to pile into long-term bonds--which typically yield more than short-term ones--and they got creamed when interest rates rose sharply.

The lesson: Don't be a yield hog. "I don't think people should be in the long-term sector now--no way, shape or form," says bond specialist Marilyn Cohen, head of Envision Capital Management in Los Angeles. What you can do is capture most of the yield of long-term bonds by sticking with a portfolio or fund of intermediate-term bonds (five-to 12-year maturity). Ditto for one-year bank CDs (now yielding about 2.1%) to five-year CDs (3.7%). "You don't want to bet against the economy for too many years," says Cohen.

--Corporate bonds are looking sweeter than government-issued Treasuries. The spread (difference in yields) between the two types gaped with the nonstop corporate scandals of the past year, as companies had to pay higher yields to entice wary investors. Although that spread has narrowed a little (10-year corporates now pay about 1.3 percentage points more than 10-year Treasuries), it's still attractive, says Joan Payden of Paydenfunds. Bond bulls like Payden argue that a mid-investment-grade corporate-bond fund yielding 6% to 7% isn't overly risky if beating money-market yields is your goal. There's a cushion (the higher yields) should bond prices decline moderately, as they would in a typical economic recovery.

--Skittish, postbubble investors are shying away from bonds that are of investment grade but only barely--what you might call near junk--so these bonds are a good buy now, offering 9.5% or so yields in intermediate maturities. But seek safety in numbers, says Payden. Choose a fund that holds at least 75 or so different bonds rated no lower than Ba. Even if one or two of the bonds sink, you don't go down with them.

--Dividend-paying stocks, with their steady income, can help power you past low interest rates. As with any kind of stock, there can be significant price risk. Utilities and phone companies, two sectors pounded by scandal, have demonstrated that. So diversify--don't you always?--and stick to companies that have paid their dividends, even in tough times. Mark Luftig, co-manager of the Strong Dividend Income Fund, likes Bank of America, up 9% this year and yielding about 3.6%, and SBC Communications, down 22% and yielding 4%.

One more thing: dull as it is right now, you still want to hold at least 5% of your portfolio in cash, for its ultimate safety and liquidity. If the economy worsens from here, dull will look good. And when it gets better, your cash returns will too.

For more on personal finance, see time.com/money