Simple and Safe

These ten low-risk investments will help your money grow -- slowly but surely.

By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance

July 2003

Ryan and Leslie Sysko, meet Arkadi Kuhlmann. His spiffy suits fairly shout "Bull market!" and Kuhlmann has a swagger that Wall Street's Gordon Gekko would have envied. What's he up to? Would you believe he wants to sell Americans a bank account that pays 2.1%? And would you believe the Syskos are his satisfied customers? Yes, a savings account is the hip, new money thing. The world has really changed.

Kuhlmann is president of ING Direct Bank, whose Orange Savings Account has signed 1.1 million customers and attracted deposits of $15 billion in less than three years. On the day we visited ING Direct's headquarters -- located in a restored warehouse next to the Wilmington, Del., train station -- savings accounts offered by nearby banks were paying only 0.50% to 0.75%. Money-market mutual funds do little better, and some pay virtually nothing. To add to the Orange account's appeal, it has no fees or minimum-balance rules. You can start with $1 and make withdrawals anytime.

For Leslie and Ryan Sysko, who are in their twenties and expecting their first child this summer, the account is ideal. Leslie, a technical writer, moves money in and out of Orange Savings between paychecks. That way, she and Ryan, who teaches online marketing to insurance-company employees, earn something on the savings they are building both for the baby and to pay for extensive home renovations.

The Syskos, who live in Wilmington, know 2.1% per year over a lifetime won't set them up for retirement or establish much of a college fund for their child. They have some money in stocks, but their emphasis now is on low-risk bank accounts so that they don't have to "depend on cashing out stocks six months later when the value could be down," Leslie says.

Besides, 2.1% is not just better than 0.75%. It beats a loss of any magnitude, and losses are something that too many of us have endured over the past three years. ING's Kuhlmann believes that consumers would be wise to focus on safety for years to come. "I don't see any great new growth or investment stories out there," he says. That's his opinion, he adds, but it's also what customers have been telling him.

In any case, don't interpret our praise of safe investments as a suggestion that you abandon stocks. But there's no reason to shortchange your savings or expose yourself to undue peril. Here are ten low-risk investments, starting with the simplest and safest, and progressing to (relatively) safe mutual funds and stocks.

A parking place

ING can change the rate on its Orange Savings Account (800-464-3473) anytime it desires. The bank says it pays at or close to two percentage points below what it charges for home-equity loans and adjustable-rate mortgages, so if rates on those products rise, so will the yield on the savings account. ING says it beats what other banks pay because of low operating costs and, frankly, because it wants to.

Watch for ING to draw imitators. To see the latest list of top-yielding bank money-market accounts, visit Kiplinger.com.

Smart government bonds

When it comes to the certainty of payoff, there's nothing safer than Treasury IOUs. But government-agency bonds come close. Debt issued by such outfits as Fannie Mae and the Tennessee Valley Authority are as safe as Treasuries -- and they pay better.

Jay Chitnis, strategist at YieldQuest, a bond advisory firm in Atlanta, recommends bonds with maturities of about six years, the point at which he believes you get the best yield without too much risk to principal. That gets you 3.7% on a Federal Farm Credit or a Federal Home Loan Bank note, versus 3.1% from a Treasury of the same maturity. "This is a terrific value," he says. You'll need a brokerage account to invest. Some brokers will let you invest in such bonds with as little as $1,000.

An alternative is an intermediate-term government-bond fund. The rub with funds is that they never mature, so if interest rates rise, a fund will probably lose value. With individual bonds, by contrast, you get your principal back if you hold to maturity. Funds also extract operating expenses. A good choice is Fidelity Intermediate Government Income (symbol FSTGX; 800-343-3548). The fund holds about a third of assets in Treasuries and most of the rest in agency debt and mortgage securities. It sports a 30-day yield of 2.7% and has returned an annualized 7% over the past five years to May 1.

Stable values, good yields

The "stable value" concept, borrowed from the insurance industry, is slowly being applied to mutual funds that are available for IRAs, 401(k) retirement plans and 529 education savings accounts. A stable-value fund promises decent yields and is designed to maintain a steady share price. For example, PBHG IRA Capital Preservation Fund (PBCPX; 800-433-0051) currently yields 3.6% and has held steady at $10 per share since its inception in 1999.

Stable-value funds are not money-market funds. Instead of investing in super-short-term IOUs, as money funds do, stable-value funds own such things as mortgage bonds and credit card receivables. Since the value of those kinds of debt instruments can fluctuate, keeping a stable-value fund's net asset value, well, stable requires financial engineering. The key is a "wrapper," an insurance agreement designed to give the fund money to redeem shares at a stable price even if the value of its holdings were to drop because of a rise in interest rates (bond prices generally move inversely with yields). The cost of this insurance typically trims a fund's yield by 0.15 to 0.25 of a percentage point, says Laura Dagan of Dwight Asset Management, a stable-value specialist in Burlington, Vt., that manages the PBHG fund.

Stable-value funds are sold only for retirement accounts because they are not prepared for heavy redemptions. But the concept is catching on, and more companies plan to open stable-value funds. That has attracted the attention of federal regulators, who are examining whether the funds disclose enough about the wrappers. Dagan says regulators worry that new entrants might botch their funds so profoundly that the insurance will become unavailable. For now, this shouldn't deter you from considering these low-risk funds.

Tax-free and worry-free

Unlike Uncle Sam, a state or local government or some other municipal entity can theoretically default, as Washington State's public-power system did in the 1980s. Municipal bankruptcies are rare, but a rating agency's downgrade of a city or state government is not. When that happens, the value of a municipal bond can drop by as much as 10%.

You can protect yourself from downgrades and other unpleasant local developments by buying insured municipal bonds. Like nearly all munis, interest from insured bonds is exempt from federal income tax. An issuer, such as a college-dorm system or a city hospital, buys the insurance from a private company when it issues the bonds. The insurance guarantees timely payment of principal and interest, although it won't protect you from price moves because of changes in bond yields. The insurance is not free, meaning that an insured bond will almost always yield less than a similar uninsured bond. Rating agencies usually give insured bonds their highest ratings.

It's generally better to buy munis that are issued in your home state. That allows you to avoid state as well as U.S. income taxes. Muni bonds usually come in $5,000 increments. You have to buy them through brokers, who can provide yield and price information. One good source on the Internet for news and data is Bondsonline.com.

Relatively few mutual funds focus on insured munis. The best of the lot is Vanguard Insured Long-Term Tax-Exempt (VILPX; 800-635-1511). A big plus is Vanguard's ultralow fees (the annual expense ratio is 0.18%). Despite its name, the fund is not loaded with super-long-term bonds; recently, its average maturity was less than nine years. That will minimize the pain when interest rates turn up. The fund's 30-day yield was recently 3.4%, or the equivalent of 4.9% from a taxable investment for someone in the 30% tax bracket. Over the past five years, it has returned an annualized 6%.

Easy corporate bonds

"If Wal-Mart sold bonds, this is what they would sell," says Patrick Kelly, head of a division of Chicago's LaSalle Bank that sponsors Direct Access Notes. These are short- and intermediate-term obligations of investment-grade corporations sold in slices of $1,000.

You buy direct notes through a broker. Interest rates are set weekly, and the $1,000 price includes commission (which is reflected in the rate). Weekly offerings appear at Direct-Notes.com and at such competitors as Bank of America's InterNotes. Recently, for example, GMAC Smart Notes maturing in 18 months yielded 2.6%, three-year notes yielded 4% and IOUs due in 15 years yielded 6.9%. GMAC, the financing arm of General Motors, can redeem the 15-year notes at face value starting in 2006. Standard & Poor's gives GMAC a rating of BBB -- not top of the line but still investment grade. Yields from higher-rated issuers are lower.

Direct notes are good for building a laddered bond portfolio. That means spreading assets among bonds (or CDs) with a variety of maturities -- say, one, two, three, four and five years. Then, every year when a bond matures, you buy a new five-year IOU. With laddering, you lock in higher rates with some of your money. That's good in case interest rates fall. But you also have something maturing every year for reinvestment. That's desirable when rates rise.

Direct notes do not promise a stable market value, but because the maturities tend to be short, you should plan to hang on until your principal is returned. If you must sell early, brokers will buy them or LaSalle will make an offer for its own account, but you may have to accept a price below face value.

Real estate with less risk

Real estate investment trusts are the route to regular income from commercial real estate, such as apartment complexes, office buildings and malls. REITs (rhymes with treats) trade like stocks and must distribute 90% of their profits as dividends or suffer crippling tax consequences.

Because of real estate booms and busts, REITs as a group have been known to fall as much as 15% in a single year. However, if you buy and hold, REITs should beat bonds over ten, 15 or 20 years, helped by predictable dividend yields of 7% or so. And because REITs exhibit relatively little correlation to the overall stock market, many advisers suggest including them in portfolios to improve diversification.

Huge REITs, such as office developer Boston Properties (BXP; recent price $40; yield 6.1%) and mall owner Simon Property Group (SPG; $39; 6.2%) won't get you into trouble. To minimize risk, though, you'll probably want to buy REITs through a fund. Good no-load choices are Fidelity Real Estate Investment (FRESX; 800-343-3548) and Stratton Monthly Dividend REIT Shares (STMDX; 800-472-4266). The Stratton fund, which yields 7%, has returned an annualized 6% over the past five years and 16% over the past three. The Fidelity fund yields just 3.7%, but its performance has been similar, gaining an annualized 6% over the past five years and an annualized 14% over the past three.

Superb all-in-one funds

A balanced fund, which typically invests in blue-chip stocks and high-quality bonds, isn't for everyone. If you've got enough money to meet a host of minimum-investment requirements, you're generally better off creating your own balanced portfolio consisting of the best stock and bond funds that are appropriate for your circumstances. Still, there's no denying the appeal of one-decision funds that do the balancing for you. And if you choose a balanced fund from a company that excels at both stocks and bonds, you'll sleep well.

Vanguard Wellington (VWELX; 800-635-1511) and Dodge & Cox Balanced (DODBX; 800-621-3979) are class acts. Both funds typically keep 60% of assets in stocks, the rest in high-grade corporates. Dodge & Cox Balanced, established in 1931, lost 3% in 2002, its first down year since 1981. It has gained an annualized 7% over the past five years and 11% over the past ten. Wellington, founded in 1929, lost 7% last year but has been almost as consistent as Dodge & Cox. It returned 3% per year compounded over the past five years and 10% over the past ten.

Low-risk wheeler-dealer

If you invest in a company because it's a supposed takeover candidate and then discover that no deal is in the works, you can be annihilated. But merger investing isn't always so scary. Consider Merger fund (MERFX; 800-343-8959). It invests in stocks of companies that have already agreed to a takeover or some other kind of deal. Its success is based not on forecasting a company's earnings, but on judging which deals will be consummated and which are likely to collapse.

Merger fund's results are excellent -- a ten-year annualized return of 9% achieved with remarkably low risk. Its 6% fall in 2002 was its first full-year loss since it opened in 1989. The fund is one-third as volatile as Standard & Poor's 500-stock index, and it shows little connection with the overall market, making it a fine choice for smoothing a portfolio's ups and downs.

Premium preferreds

With their fixed dividend payments and generous yields, preferred stocks are a lot like bonds. Companies must cut or omit dividends on common stocks before they touch the payout on preferreds. However, bondholders get priority over preferred investors for a claim on a company's assets should it get into trouble. Like bonds, preferreds are also sensitive to swings in interest rates, moving up in value when rates fall, and losing value when rates rise.

You can find an extensive list of preferreds and quasi-preferreds (brokerage-concocted products that go by such acronyms as Prides and Toppers) in the Wall Street Journal. You can also check with full-service brokers for their preferred preferreds. It's best to stick with high-quality issuers. For example, Consolidated Edison, the New York electric utility, has a preferred, rated A- by S&P, that pays a $1.25 quarterly dividend. At a recent price of $85, the preferred (symbol ED.A) yields 5.9%.

American idols

After all this, you may think we hate common stocks. Not so. The economy grows more often than it shrinks, and great companies can stand tall in any market or economic cycle.

We sought two armor-plated stocks by screening for safety and soundness, as well as for consistent profit and dividend growth, in Value Line's database. We looked for stocks that had produced compounded annual returns of at least 15% over the past ten years. We also eliminated any stock that had experienced steep declines over any six-month period during the past five years. The result is these two classics.

Anheuser-Busch (BUD) may be a leading purveyor of liquid refreshment, but its finances are as solid as the holdings in Fort Knox. Although the beer business grows slowly, Busch boosts its profit margins and earnings relentlessly. Profits have climbed 13% per year over the past five years, even though sales rose just 4% annually. Acquisitions and weak competition should enhance sales growth. The stock, at $51, yields 1.5%, and Busch raises the dividend regularly. Investor Chuck Whitaker of New Haven, Ind., sees his recent purchase of Bud stock as a key step in making his battered stock portfolio safer. "The company is stable, the management is good, and the stock is in a good trading range," he says.

Wells Fargo (WFC) calls itself "one strong box," a pun on the lockboxes it carried west on stagecoaches. It combines banking, money management, brokerage and mortgages into a financial-services powerhouse. It beats its peers in virtually every measurement of a bank's health and consistently hikes its dividend. At $51, the stock yields 2.3%.

--Reporter: Joan Goldwasser

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