There was a lot of noise in the investment markets around rising rates last year, but for investors with a lot of cash, the story was pretty much the same: paltry yields on bank accounts and money market funds. With interest rates so low, you may have wondered whether you should just stuff your cash under a mattress.
But while finding yield in the short-term market has been challenging, it isn't impossible. You may be able to boost the income your cash allocation produces—but the downside is that you have to take on greater risk.
To determine whether it makes sense to accept greater risk in exchange for greater yield potential, consider the purpose for your cash investments. In some cases, you may require absolute stability, but in others you may be willing to accept some possibility of declines in exchange for higher interest payments. The decision comes down to your needs: the role this allocation plays in your overall portfolio, and what you hope to get out of it given your needs and time horizon.
Low yields explained
In December 2008, the Federal Reserve cut the target federal funds rate—a key benchmark for short-term interest rates—to a record-low range from 0.00% to 0.25%. The Fed’s goal was to help pull the U.S. economy out of a deep recession and financial crisis. Many experts expected that rates would rise back to more normal levels after the economy stabilized. But more than five years later, still-high unemployment and a slow-growth recovery have persuaded the Fed to keep this influential short-term rate at its historical low.
The low federal funds rate has acted as an anchor on yields offered by short-term instruments such as Treasury bills, deposit and savings accounts, money market funds, and other short-term bond funds. The average prime money market fund paid a seven-day yield of just 0.01% as of March 18, 2014, according to money fund tracker iMoneyNet, while yields on Treasury bills with maturities of three months or shorter hovered below 0.05%, and have even dipped into negative territory, at times, during the past five years, when nervous investors flocked to the highest-quality securities.
Digging into risk
Some shorter-term investment options offer significantly more yield than money funds and T-bills, but generally have either lower credit ratings or longer maturities than the securities that make up traditional short-term holdings. Those characteristics make the securities more vulnerable to declines, so you may need to be able to stomach minor downturns in your principal value, depending on the use you have in mind for your money. In general, most investors manage the risk level of their portfolios by making decisions about the equity allocation or fixed income allocation. But to a lesser extent, you can make these same choices within the short-term portion of your portfolio.
Bear in mind the following risks when determining whether to pursue higher yield with a portion of your cash allocation.
During the 2008 financial crisis, investors fled areas of the financial markets with even a whiff of risk, in favor of Treasuries. As a result, the spread—the gap between yields—of corporate bonds over Treasury bonds grew to historically wide margins.
Spreads have narrowed back to prerecession levels. Even so, corporate issues still pay significantly more yield than Treasuries, to compensate for the greater risk that the issuer will default. The greater the risk, the larger the yield premium a corporate bond or bill offers compared with a Treasury with a comparable term.
|More credit risk may mean more yield||Yield|
|Higher credit quality||Government-backed 3-month Treasury bills||0.05%|
|Lower credit quality||Investment-grade 3-month corporate paper (financial)||0.12%|
|Data as of 3/14/14. Source: WSJ.|
Whether it makes sense to reach for yield by extending further down to weaker credit ratings—and how far it makes sense to reach—depends largely on how you intend to use your investments. If you need the money for everyday expenses, you probably can’t abide any fluctuation in the value of your principal, so you may want to consider a money market fund, one of the lowest-risk investment options.1
On the other hand, you may be able to tolerate the occasional blip in your account balance—for example, when investing the cash allocation of a long-term portfolio or a portion of your emergency fund. In that case, you may want to hold a portion of your cash in higher-yielding securities.
If you do want to invest in lower-rated securities, it is important to remember that lower credit ratings usually indicate a weaker balance sheet and a higher risk of bankruptcy for bondholders. So it is important to perform research on the underlying company and the specific features of an individual bond—or you could invest in a bond fund to tap into professional research and management capabilities.
Interest rate risk
Another way to secure higher yields is to hold securities with longer terms. In general, when two bonds with comparable credit ratings have different maturity dates, the one with the longer term will typically pay more yield, and be more sensitive to interest rate changes.
Investors chart the different yields offered by bonds with various maturities on a graph called the yield curve. The graph recently looked like the chart to the right.
Fixed income investors refer to the difference between the yield of longer- and shorter-maturity bonds as the steepness of the yield curve. When the yield curve is steep, it means that you can earn more income by investing in longer-maturity bonds. The same principle holds true for different maturities on the shorter end of the curve: Typically, a longer-maturity bond will offer more yield than a shorter-maturity bond, even if you are comparing one- and three-month bonds or one- and three-year bonds.
The trouble is that longer-term bonds carry greater interest rate risk: If the general level of interest rates rises, bond prices will usually fall—and they’ll fall further for longer-term bonds than for shorter-term bonds.
A bond’s sensitivity to interest rate changes is expressed by its duration (technically, the weighted average time until the bond’s future payments). As a rule of thumb, an investment-grade security with duration of 1.9 could be expected to lose approximately 1.9% each time interest rates rise by 1%. Likewise, it could gain 1.9% when interest rates drop by 1%.
Considering that interest rates are hovering at or near their historic lows, they have much more room to go up than down, causing many investors to worry about potential interest rate risk. Some investors are limiting their holdings to very short-term securities to limit the damage from any interest rate hikes. But these investors are earning little to no yield on such securities—and no one knows when interest rates will rise.
Again, consider your need for cash. If you are looking for the least risk, keep your money in a money market, savings, or checking account. If you do use one of these accounts, look for higher introductory interest rates that may be available, and watch out for ATM surcharges, minimum balance fees, and other charges. If you can handle a decline in your principal, you may want to hold a portion of your allocation in longer-term securities.
According to Kim Miller, manager of Fidelity® Conservative Income Bond Fund (FCONX), "An investor in a money market fund is probably earning between 0.01% and 0.10% right now. The yield curve changes daily, of course, but an investor willing to take on a little more price risk and principal volatility—less than a typical short- to intermediate-term bond fund might offer—could pick up between 0.20% and 0.30% in yield for some of their short-term assets by moving out the curve marginally, to a duration of three to six months."
In that case, you might consider shifting part of your short-term allocation to an ultra-short- or short-term bond fund. Or, if you prefer to invest through individual issues, you may want to build a ladder of bonds or CDs with sequential maturity dates—for example, holding equal amounts in securities with 6-, 12-, 24-, and 36-month maturities.
Find up to date yield data
"Despite low levels of absolute yields, the yield curve—which shows the difference between long- and short-term interest rates—is still moderately steep," says Richard Carter, Fidelity vice president of fixed income products and services. "This means that a six-month Treasury bill offered a 0.09% yield, a two-year Treasury note yielded 0.63%, and the three-year Treasury note as much as 1.08%.2 That is a significant differential. Providing that you are comfortable with the staging of your maturities, have enough cash on hand to meet your needs, and invest in high quality credits, you can allow the investments to mature at par (the face value of a bond), and not concern yourself with day-to-day price and valuation changes."
Making your choice
When deciding how to invest your cash, make liquidity—how quickly you need access to the money—a central consideration. In general, the more comfortable you are with risk and the less liquidity you need, the more yield you can afford to pursue.
Consider the following hypothetical examples:
|The goal: Everyday expenses||The goal: Emergency fund|
|The goal: Near-term savings target||The goal: Low-volatility, "short-term" allocation in long-term portfolio|
Beyond investment performance
The yield you can earn on your cash isn't the only consideration you may want to keep in mind. Fees can eat into your returns and savings, in fact the average American spends nearly $300 dollars per year in bank fees. So shop around for competitive pricing on services including ATMs, bill pay, and checks. You may also want to consider the insurance offered on your account. A single bank account typically offers each individual $250,000 of FDIC insurance protection, and brokerage CDs also provide insurance. Some brokerage cash management accounts offer insurance and may even structure services to provide protection to more than $250,000, but others dont' offer any. So you may want to weigh that factor when deciding where to park your savings.
The bottom line
Even in low-rate environments, there are ways to increase the returns on short-term investments. But with investing, there is no free lunch. More yield generally requires assuming more risk. The key: make sure your choices match up with your goals and your personal tolerance for risk.
Before investing in any mutual fund, please carefully consider the investment objectives, risks, charges, and expenses. For this and other information, call or write Fidelity for a free prospectus or, if available, a summary prospectus. Read it carefully before you invest.
‘AA’—Very strong capacity to meet financial commitments.
‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
‘BBB’—Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
‘BBB-'—Considered lowest investment grade by market participants.
‘BB+’—Considered highest speculative grade by market participants.
‘BB’—Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.
‘B’—More vulnerable to adverse business, financial, and economic conditions but currently has the capacity to meet financial commitments.
‘CCC’—Currently vulnerable and dependent on favorable business, financial, and economic conditions to meet financial commitments.
‘CC’—Currently highly vulnerable.
‘C’—Currently highly vulnerable obligations and other defined circumstances.
‘D’—Payment default on financial commitments.
Changes in government regulations, changes in interest rates, and economic downturns can have a significant negative effect on issuers in the financial services sector.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, and instrumentalities is generally exempt from state income tax but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.