Money Matters
The Independent Press September 6, 2006
Skloff Financial Group Questions Interest Rates
By Aaron Skloff Question: It seems like I am always paying high interest rates. Is there a way I can earn high interest rates? Ever wonder how banks make so much money? They ask you to make deposits and pay you a modest interest rate, typically 3%. They then take your deposit and loan it to homeowners and companies at a higher interest rate, typically 7%. This generates a healthy profit of 4%. Quite attractive…for the bank. Many companies skip the bank and obtain loans directly from the public by issuing bonds. When a company issues a bond they are legally obligated to repay the amount borrowed (the principal) and the periodic interest – similar to a certificate of deposit (CD). Unlike a CD, which is insured by the FDIC and pays a modest interest rate, company issued bonds pay a higher interest rate. Quite attractive…for the investor. Like most investments, the higher the risk, the higher the reward. Independent credit rating agencies, such as Standard & Poors and Moody’s rate bonds based on risk. They may rate a bond AAA if they believe it is a safe investment and rate another bond B if they believe it is a riskier investment. Bonds issued by safer companies receive higher credit ratings and pay lower interest rates. Bonds issued by riskier companies receive lower credit ratings and pay higher interest rates. For example, if General Electric were to issue AAA rated bonds they would be considered safe. Because they are considered safe, they may only pay an interest rate of 6%. In comparison, if General Motors were to issue B rated bonds they would be considered riskier. Because they are considered riskier, they may pay a higher interest rate of 8%. A portfolio of bonds, such as those offered inside a mutual fund, provides exposure to a variety of bonds. If one particular bond inside the mutual fund were to default, the other bonds could more than offset the difference. Adding a portfolio of bonds to a portfolio of stocks has resulted in reduced risk to an overall investment portfolio. Note: Aaron Skloff, Accredited Investment Fiduciary (AIF), Chartered Financial Analyst (CFA), Master of Business Administration (MBA) is CEO of Skloff Financial Group, a Registered Investment Advisory firm based in Berkeley Heights. Call 908-464-3060.