In the current market it is difficult to find a safe place to invest if you are looking to preserve principal. Many asset classes, including commodities and equities, appear potentially overvalued and are highly volatile. Meanwhile, low interest rates and the threat of rising inflation augur poorly for many fixed income securities. Where can you put your money in this environment? The following are four ideas of conservative investments that can be expected to hold their value.
TUTORIAL: Safety and Income: Bonds
U.S. Treasury inflation protected securities (TIPS) are attractive in this environment because they offer a guaranteed hedge against inflation. The interest rates offered are very low, but the goal with TIPS is capital preservation. The principal amount of TIPS is adjusted semi-annually so that it keeps pace with inflation, as measured by the Consumer Price Index (CPI). A fixed interest rate is paid on the adjusted principal. Thus, when you buy a TIPS you are able to preserve purchasing power and earn a small real rate of return. The disadvantage of TIPS is that they are very tax inefficient. The inflation adjustments to the TIPS are treated as income each year, even though an investor does not actually receive the cash from these adjustments until maturity. To avoid this "phantom income" problem, it is often advisable to hold TIPS in tax advantaged retirement accounts where the tax man cannot reach them. (If you want to protect your portfolio from inflation, all you need are a few TIPS. For more, see Treasury Inflation Protected Securities.)
U.S. inflation-linked savings bonds (I-Bonds) are the other go-to option for guaranteed protection against inflation. I-Bonds pay a variable interest rate. This rate is the sum of a fixed real interest rate and the inflation rate, determined by the CPI. The method of adjusting for inflation is different that TIPS, but the effect is the same: money invested in an I-Bond will keep its purchasing power. Compared with TIPS, I-Bonds are far more tax-friendly because taxes of the interest earned on the bond can be deferred until you redeem the bond. There is no phantom income problem. Unlike TIPS, which have a fixed maturity date, I-Bonds are more flexible, returning the principal amount whenever they are redeemed by their owner. I-Bonds have a minimum holding period of one year, and an early redemption penalty if redeemed before five years.
A disadvantage of I-Bonds is that it is only possible to buy up to $10,000 in I-Bonds per year. Each person can buy up to $5,000 electronically, and another $5,000 in paper bonds. This can be an issue for investors with significant assets. Another point to consider is that since the I-Bond is redeemable after one year, the interest rate paid on these securities is relatively low. Investors who are able to tie up their money for longer may prefer non-redeemable securities that offer have higher yields. (For more, see Hedge Your Bets With Inflation-Linked Bonds.)
3. Short-Term Bond Funds
High quality corporate, municipal, or government bonds are the traditional place to invest money when you need stability of value. For the safest bet, you will want to stick with short-term bond funds, since long-term bonds fluctuate in value significantly with changing interest rates. The value of short-term bond funds decline significantly less in an increasing interest rate environment. This is because portfolio managers holding short-term bonds are not tied to below market interest rates for long. Upon maturity, they can reinvest money in higher yielding instruments. Investors seeking safety will want to look for funds that hold bonds with the highest credit ratings, indicating that they are unlikely to default on payments. They will also want to verify that so-called short term bond funds do in fact hold a portfolio with an average maturity of five years or less.
4. Bank CDs
Certificates of deposit (CDs) may not be exciting, but they are some of the safest investments around. If you are willing to shop around with a variety of banks and credit unions, it is possible to get a rate on a CD that significantly exceeds the return available on a comparable U.S. Treasury security. As long as you stay under the FDIC insured limit (currently $250,000 per depositor per insured bank), then the return of your money is still guaranteed by the U.S. government. CDs don't offer a hedge against rising interest rates, so it may be wise to stay with shorter maturities. It is also possible to simply pay the early termination penalty if rates rise sharply, something that may be worthwhile if you are locked in at a lower rate for a long period. (Certificates of deposit promise stable income in any market, but do they deliver? For more, see Are CDs Good Protection For The Bear Market?)
TUTORIAL: Certificates of Deposit
The Bottom Line
If you have money that you can't afford to lose, any one of these options represents a low-risk low-return solution to preserving principal. You won't earn much in returns with these securities though. In most cases it will be just enough to keep level with inflation. If you need capital appreciation over the long term, you'll have to take on more risk.