As we enter into an environment where interest rates are rising it is very important to understand how the US dollar is impacted. As investors try to navigate the volatility of the market and make sure their investment portfolios are outpacing inflation it often helps to return to the foundation of how we use the dollar in our economy. The three main uses for the US dollar include; spending, lending, and/or owning.
If you have a dollar you can buy a hamburger, pay a bill or get a haircut. You can use the dollar to purchase goods and services that have no inherent monetary value.
The second thing you can do with a dollar is lend it. Lending your dollar means to give your dollar to an entity that will pay you interest for a specific length of time. The common way of lending is to give your dollar to a bank (savings account) and the bank will pay you interest as long as you keep the money in the account. Investors who want a higher rate of return from the bank can look at Certificates of Deposits. CD’s pay a higher rate of interest because you tie up your dollar for a specific time period (1 month to 5yrs).
You can lend your dollar to the U.S Government (Treasuries). The government will pay you an interest rate depending on the maturity. The longer you go out the higher the rate of interest.
Another place to lend your money is Corporate Bonds. By lending your dollar to a corporation (IBM, APPLE) you will receive a fixed interest payment usually paid every 6 months for a specific amount of time. These corporate bonds usually pay higher interest rates than the bank but do have more risk. The longer the maturity is the higher the rate of interest. The higher the risk (can the corporation make its interest payments and pay the bond back at maturity) the higher the interest rate. All of the above examples of lending are taxable.
You can also lend your dollar and receive a tax free interest payment. Municipal Bonds are issued by states, state agencies & local governments. The interest is federal tax free and can be state tax free if you lend within the state you reside.
All these lending vehicles can be done within a mutual fund that can specialize in all or some of the types listed above. By investing in a mutual fund you can diversify your lending in both the type of bond and the length of maturing which can ultimately lessen your risk. This lending is known as “fixed income” investing.
The last thing you can do with your dollar is own your dollar. You can buy a house, buy stock in a corporation, buy a business, buy collectibles or buy many other assets. Buying means you own an asset. That asset may increase or decrease in value but you own it. When you invest in a stock, you own a piece of the corporation (hoping the value goes up). Owning your dollar usually is called equity investing. As with bonds you can invest in a mutual fund to diversify your dollars owned which can also lessen your risk.