Rising rates make cash more interesting

Rising Rates Make Cash More Interesting

For most investors, money market funds are quite literally the last thing they think about. Also known as “cash,” a money market fund is where you usually keep what’s left over in your portfolio after you have decided how much to invest in stocks and bonds, as well as real assets and diversifiers. It’s the money you’d like to have readily available for short-term needs, and therefore should have low risk of losing the principal amount.

Holding cash has been especially boring for most of the last 10 years thanks to the Federal Reserve holding short-term interest rates below 1%. These extremely low interest rates helped boost returns for other investments, but they made holding money market funds unappealing.

Finally, we’re seeing short-term interest rates rise to a point where you can now make a reasonable return on your cash holdings. But which cash investment is best for you? There are many choices other than standard sweep money market funds, and selecting the right one depends on your unique situation including your goals, time horizon and tolerance for risk.

The benefit of rising short-term interest rates

For the last few years, equity gains were fueled by money pouring into the stock market by investors who felt there was no other reasonable alternative. Compared to historical norms, bond yields were extremely low, below 1% for short-term bonds, and money markets earned next to nothing. In this environment, investing in stocks looked like the best option, and questions about how much cash to hold had one easy answer — keep as little as possible.

Now, things have changed. In June, the Federal Reserve increased short-term interest rates for the seventh time since December 2015. The fed funds rate — the interest rates banks can earn on excess reserves held overnight at the Federal Reserve — is now set to a range of 1.75% to 2.00%. The consensus forecast is for the Fed to raise rates two more times this year, and then another two or three more times in 2019. If events play out this way, the fed funds rate will ultimately rise to about 3.00% or so.

Not only have stocks and bonds become more expensive overall, but money market yields have increased significantly, relatively speaking. Although the yields on sweep money market funds have risen only slightly and remain low, at 0.2% or so, the yields on some purchased money market funds and short-term bond funds now match the dividend yields paid by some stocks. For investors who are focused on income, you can now hold relatively safe assets that produce as much income as riskier stocks.

As interest rates continue to rise, the returns from investing in money market funds, as well as other short-term bond funds, should rise as well. This will give us better options for earning more attractive returns on our short-term cash holdings.

Best options for enhancing cash yields

Here are four types of cash holdings to help you eke out a little more income for minimal risk.

  • Option 1: Slightly less conservative money market funds
    Custodians such as Charles Schwab, Fidelity and T.D. Ameritrade offer money market funds that provide stability and liquidity, but with yields that are meaningfully higher than those of the default sweep money market fund. These higher yielding funds often must be purchased and sold like an investment in a mutual fund, so your cash may not be immediately available if needed unexpectedly. These purchased money market funds are also not insured like many sweep funds, meaning slightly more risk. But they are usually managed to preserve a constant net asset value (NAV) and may impose liquidation fees and redemption gates.

    The yield enhancement is roughly 0.70% to 0.85% above the default cash selection.

  • Option 2: Ultra-short-term bond funds
    If your time horizon is at least 12 months, an ultra-short bond fund may be an appropriate vehicle for holding cash. Please note, these funds have fluctuating NAVs and involve some risk of principal loss, but the risk of a 12-month negative return is very low.

    The yield enhancement would be roughly 1.4% to 1.8%.

  • Option 3: CD ladders
    Another option if your time horizon is at least 12 months is a short ladder of certificates of deposit (CDs) that mature within a year. CDs are generally safe, thanks to the FDIC insurance of up to $250,000 per bank. But there is a risk of loss if you need to sell the CD prior to maturity.

    If you can hold onto the security until maturity, they offer attractive yields. The yield enhancement for an individual CD may be between 1.5% and 2.0%, depending on the invested amount and term.

  • Option 4: Short-term bond funds
    For those who have a longer time horizon and are willing to risk some loss of principal, a short-term bond fund may be an attractive option. These funds are more appropriate for strategic cash allocations, which generally means a time horizon of greater than two years. Index mutual funds and exchange traded funds are usually the cheapest, but there are also some actively managed bond funds that are low cost and perform well.

    The yield enhancement is expected to be roughly 1.5% to 1.9%.

Also note that for taxable accounts, it’s almost always best to invest in a fund that holds municipal securities versus holding CDs, Treasuries or taxable money market or short-term bond funds.

Bottom line

When short-term bond yields were near zero, it didn’t matter where you parked your cash. But now that interest rates are starting to rise, deciding how to invest cash is becoming interesting again. If rates continue to rise as many expect, the gap between sweep money market rates and other cash vehicles could widen further. Consult your wealth manager to determine which option is best for your cash management needs.

The information provided is general in nature and is not intended to be, and should not be construed as, investment, legal or tax advice. All investments involve risk.