As uncertainty besets the economy, the markets, and the outlook, millions of Americans, their businesses, and their charities are hoarding cash, prudently keeping a cushion in case of job loss, business turndown, or cash flow shortage.
Although we want to be safe, we also want some return. Historically, inflation has marched along at a 3.5% pace; just stuffing cash in the mattress subjects you to that annual loss and losing half your purchasing power in 20 years.
The rub is, in order to generate higher returns, you must take greater risk. What risks are we talking about? The two key ones are, first, credit risk, or the risk that the borrower fails to repay you; and second, interest rate risk, or the risk that interest rates rise, causing your investment, fixed at the preexisting, lower rates, to be worth less.
One traditional way to boost your return is to lend to slightly less creditworthy borrowers. The typical way to mitigate that risk is to diversify amoung the types and number of borrowers.
The other traditional way to boost your returns is to lengthen maturities, in other words agreeing that the borrower need not redeem your money for a longer period of time. The typical strategy to reduce the interest rate risk of extending your maturities is to diversify among various maturities.
In Sum
Historically, small temporary savers did better in non bank money market funds than bank money market funds or certificate of deposits (CDs). Now, the competition by banks to retain their customers has created a favorable interest rate advantage for these bank products.
To deposit more than the $250,000 FDIC insured limit in any one bank is to court credit risk. Diversify over several banks to ensure all deposits are insured. To stash greater amounts than can be deposited in covered accounts, consider bond mutual funds. For truly large stashes, a combination of direct holdings of Government and corporate bonds, plus bond mutual funds, will be optimal.
Let's review your short term investment options:
Bank Money Market Funds
The beauty of bank money market funds is you take no credit risk as long as you stay under the caps for FDIC coverage, generally $250,000. Nor do you have any interest rate risk, as rates will adjust with market conditions and you can always withdraw your money to take advantage of other opportunities. Unfortunately, the prevailing rates are low, as the national average is just 0.22%, although that still trumps 90 day Treasury bills' 0.13%. If you are willing to shop around and bank over the internet you can do better; Ally Bank, the new moniker for GMAC, offers 1.28%. Of course, after the account is set up, the rate could decline. Depositors often face restrictions on the number of withdrawals, annoying paperwork when trying to withdraw, and low balance fees.
Mutual fund (non bank) money market funds generally yield less (national average being 0.04%) and are not FDIC guaranteed. However, most analysts believe that in a crisis, the Government would stand behind them, as it did in late 2008. For optimal safety, stick with the biggest money market fund providers, like Fidelity and Vanguard, which are widely considered too big to fail.
Certificates of Deposit
Being bank products, they, too, boast no credit risk. However, there's absolutely no justification for exposure above the FDIC coverage limits.
CDs' big virtue is their higher yields. The national average for a one year CD is 0.7%, twice what you'd get on a similar maturity Treasury. The downside is that most investors have too much to stay under the FDIC cap, there are penalties for early withdrawal, and you start to court some interest rate risk, as rates could rise during the period of your lock up, causing you a missed opportunity.
The further out you go, the more yield you pick up, but the more likely rates will rise during the period and the longer you'd be locked in at the old rates. The national average on a five year CD is 2.03%, but those willing to bank over the internet can net up to 3%.
Of course, if rates fall, you are protected, and will then earn an above market rate.
Treasuries
Treasuries ensure no credit risk. Because of extraordinary global demand and their premier liquidity, the rates are historically low, with 90 day Treasury bills yielding just 0.13%. Nevertheless, this is more than mutual fund money market funds pay, due to those funds' internal fees. If you've got a very large sum of money, this is as safe as stuffing cash in your mattress yet a better yielding and more flexible approach.
Bond Mutual Funds
These funds represent diversified, professionally managed (or not managed if of the index variety), collections of various credit instruments. To the extent they contain non Treasuries you court credit risk. High yield or junk bond funds have risks similar to equities, and are to be avoided by those looking for a safe, short term repository.
Credit risk is minimized because of the diversification among issues and the professional supervision if employing actively managed funds.
However, interest rate risk rises to the fore because maturities are much longer than, say, the typical CD. How much risk do you court if you extend your maturities? The rule of thumb is that your principal will adjust down (or up) by a percentage equal to the duration of your instrument for each 1% move in the general rate environment.
Duration is approximately equal to time to maturity, but reduced a bit to the extent you receive income along the way. For instance, a 10 year bond with a 4% interest rate has a duration of 8.4 years; if interest rates rose by 1%, the value of that bond would decrease by 8.4%.
The standard bond market index bond fund is constructed to replicate the performance and holdings of the Barclays aggregate fixed income index. This index has an average duration of 3.9 years and an average maturity of 5.5 years. If you are not comfortable with a potential loss in the 4% area should interest rates climb by 1%, look for a bond fund with even shorter dated holdings.
Bond mutual funds are more liquid than CDs but perhaps less convenient than bank money market funds.
Suggested Bond Funds
Vanguard Short-Term Bond Index Fund Investor Shares (VBISX) has a yield of 1.46% (1.57% if the investment is over $100,000). The average maturity of the holdings is 2.8 years (duration 2.6 years). Seventy percent of the fund is composed of Treasuries and Government agencies, while the balance is invested in corporate and foreign issues.
The Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) sports a bit more yield, 3.12% (3.23% if over $100,00). The average maturity is 6.6 years (duration 4.5 years), and the composition is similar to VBISX above but the Treasury/agency component is just 40%, while 30% are Government backed mortgage instruments.
Fidelity has similar highly regarded counterparts to these funds.
Strategy
For relatively small amounts of your cash with a definite date for use, consider CDs. Their rates are comparatively generous at the shorter maturities as banks try to hold on to their customers. Remember to check FDIC limits and use additional banks to the extent you'd otherwise go over those limits. Perhaps consider each future capital expenditure as a bucket. Fill up the near term buckets first with CDs whose maturity coincides with the expenditure date, then fill up the next furthest out, and so on.
Your other option is to use bond mutual funds for a small portion of each bucket, realizing that there will be some interest rate risk; the additional yield may offset that risk.
David Dietze
Point View Financial Services, Inc.
382 Springfield Avenue, Suite #208
Summit, NJ 07901
Ph: 908-598-1717
Fax: 908-598-1777
Email: [email protected]
Web Address: http://www.ptview.com
Although we want to be safe, we also want some return. Historically, inflation has marched along at a 3.5% pace; just stuffing cash in the mattress subjects you to that annual loss and losing half your purchasing power in 20 years.
The rub is, in order to generate higher returns, you must take greater risk. What risks are we talking about? The two key ones are, first, credit risk, or the risk that the borrower fails to repay you; and second, interest rate risk, or the risk that interest rates rise, causing your investment, fixed at the preexisting, lower rates, to be worth less.
One traditional way to boost your return is to lend to slightly less creditworthy borrowers. The typical way to mitigate that risk is to diversify amoung the types and number of borrowers.
The other traditional way to boost your returns is to lengthen maturities, in other words agreeing that the borrower need not redeem your money for a longer period of time. The typical strategy to reduce the interest rate risk of extending your maturities is to diversify among various maturities.
In Sum
Historically, small temporary savers did better in non bank money market funds than bank money market funds or certificate of deposits (CDs). Now, the competition by banks to retain their customers has created a favorable interest rate advantage for these bank products.
To deposit more than the $250,000 FDIC insured limit in any one bank is to court credit risk. Diversify over several banks to ensure all deposits are insured. To stash greater amounts than can be deposited in covered accounts, consider bond mutual funds. For truly large stashes, a combination of direct holdings of Government and corporate bonds, plus bond mutual funds, will be optimal.
Let's review your short term investment options:
Bank Money Market Funds
The beauty of bank money market funds is you take no credit risk as long as you stay under the caps for FDIC coverage, generally $250,000. Nor do you have any interest rate risk, as rates will adjust with market conditions and you can always withdraw your money to take advantage of other opportunities. Unfortunately, the prevailing rates are low, as the national average is just 0.22%, although that still trumps 90 day Treasury bills' 0.13%. If you are willing to shop around and bank over the internet you can do better; Ally Bank, the new moniker for GMAC, offers 1.28%. Of course, after the account is set up, the rate could decline. Depositors often face restrictions on the number of withdrawals, annoying paperwork when trying to withdraw, and low balance fees.
Mutual fund (non bank) money market funds generally yield less (national average being 0.04%) and are not FDIC guaranteed. However, most analysts believe that in a crisis, the Government would stand behind them, as it did in late 2008. For optimal safety, stick with the biggest money market fund providers, like Fidelity and Vanguard, which are widely considered too big to fail.
Certificates of Deposit
Being bank products, they, too, boast no credit risk. However, there's absolutely no justification for exposure above the FDIC coverage limits.
CDs' big virtue is their higher yields. The national average for a one year CD is 0.7%, twice what you'd get on a similar maturity Treasury. The downside is that most investors have too much to stay under the FDIC cap, there are penalties for early withdrawal, and you start to court some interest rate risk, as rates could rise during the period of your lock up, causing you a missed opportunity.
The further out you go, the more yield you pick up, but the more likely rates will rise during the period and the longer you'd be locked in at the old rates. The national average on a five year CD is 2.03%, but those willing to bank over the internet can net up to 3%.
Of course, if rates fall, you are protected, and will then earn an above market rate.
Treasuries
Treasuries ensure no credit risk. Because of extraordinary global demand and their premier liquidity, the rates are historically low, with 90 day Treasury bills yielding just 0.13%. Nevertheless, this is more than mutual fund money market funds pay, due to those funds' internal fees. If you've got a very large sum of money, this is as safe as stuffing cash in your mattress yet a better yielding and more flexible approach.
Bond Mutual Funds
These funds represent diversified, professionally managed (or not managed if of the index variety), collections of various credit instruments. To the extent they contain non Treasuries you court credit risk. High yield or junk bond funds have risks similar to equities, and are to be avoided by those looking for a safe, short term repository.
Credit risk is minimized because of the diversification among issues and the professional supervision if employing actively managed funds.
However, interest rate risk rises to the fore because maturities are much longer than, say, the typical CD. How much risk do you court if you extend your maturities? The rule of thumb is that your principal will adjust down (or up) by a percentage equal to the duration of your instrument for each 1% move in the general rate environment.
Duration is approximately equal to time to maturity, but reduced a bit to the extent you receive income along the way. For instance, a 10 year bond with a 4% interest rate has a duration of 8.4 years; if interest rates rose by 1%, the value of that bond would decrease by 8.4%.
The standard bond market index bond fund is constructed to replicate the performance and holdings of the Barclays aggregate fixed income index. This index has an average duration of 3.9 years and an average maturity of 5.5 years. If you are not comfortable with a potential loss in the 4% area should interest rates climb by 1%, look for a bond fund with even shorter dated holdings.
Bond mutual funds are more liquid than CDs but perhaps less convenient than bank money market funds.
Suggested Bond Funds
Vanguard Short-Term Bond Index Fund Investor Shares (VBISX) has a yield of 1.46% (1.57% if the investment is over $100,000). The average maturity of the holdings is 2.8 years (duration 2.6 years). Seventy percent of the fund is composed of Treasuries and Government agencies, while the balance is invested in corporate and foreign issues.
The Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) sports a bit more yield, 3.12% (3.23% if over $100,00). The average maturity is 6.6 years (duration 4.5 years), and the composition is similar to VBISX above but the Treasury/agency component is just 40%, while 30% are Government backed mortgage instruments.
Fidelity has similar highly regarded counterparts to these funds.
Strategy
For relatively small amounts of your cash with a definite date for use, consider CDs. Their rates are comparatively generous at the shorter maturities as banks try to hold on to their customers. Remember to check FDIC limits and use additional banks to the extent you'd otherwise go over those limits. Perhaps consider each future capital expenditure as a bucket. Fill up the near term buckets first with CDs whose maturity coincides with the expenditure date, then fill up the next furthest out, and so on.
Your other option is to use bond mutual funds for a small portion of each bucket, realizing that there will be some interest rate risk; the additional yield may offset that risk.
David Dietze
Point View Financial Services, Inc.
382 Springfield Avenue, Suite #208
Summit, NJ 07901
Ph: 908-598-1717
Fax: 908-598-1777
Email: [email protected]
Web Address: http://www.ptview.com
