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What to do with your cash
To find income potential you may have to confront risk.
For the past several years investors have had to contend with paltry yields on money market funds, CDs, and other cash equivalents. With interest rates so low, you may have wondered if you should just stuff your cash under a mattress.
But while finding yield in the short-term market is 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. “There are opportunities out there to get more yield from your short-term investments,” says Chris Sharpe, portfolio manager on Fidelity’s asset allocation team. “But you have to understand the potential risks.”
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 the possibility of minor principal declines in exchange for higher interest payments. Says Sharpe, “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 between 0.00% and 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 three years later, high unemployment and a halting recovery have persuaded the Fed to keep this influential short-term rate at its historical low point.
The low federal funds rate has acted as an anchor on yields offered by short-term instruments such as CDs, deposit and savings accounts, money market funds, and other short-term bond funds. The average money market fund paid a seven-day yield of just 0.03% as of March 15, 2012, according to money fund tracker iMoneyNet, while yields on Treasury bills with maturities of three months or shorter hovered around 0.07%, and have even dipped into negative territory when nervous investors flocked to the highest-quality securities. “In that case you’re effectively paying the government just to hold your money,” says Sharpe.
Digging into risk
Some shorter-term investment options offer significantly more yield than money funds and T-bills. They generally have either lower credit ratings or longer maturities than the securities that make up traditional cash holdings. Those characteristics make the securities more vulnerable to declines—but you may 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 pre-recession 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 to a Treasury with a comparable term.
Whether it makes sense to reach for yield by extending further down the credit-ratings ladder—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.
Investing in lower-credit-quality securities requires considerable expertise and resources, so it’s important to perform this research, or invest in a 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 pay more yield.
Investors chart the different yields offered by Treasury bonds with various maturities on a graph called the yield curve. The graph recently looked like the chart to the right.
As you can see, Treasuries with longer maturities typically offer significantly higher yield than short-term securities. Fixed-income investors refer to this situation as a steep yield curve—and it means you can boost income significantly by holding longer-term 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-month and three-month bonds or one-year and three-year bonds.
Trouble is, longer-term bonds carry greater interest-rate risk: If the general level of interest rates rises, bond prices will 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 one percentage point. Likewise, it could gain 1.9% when interest rates dropped by a point.
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 of them are limiting their holdings to very short-term securities to limit the damage from any interest-rate hikes. But those investors are earning little to no yield on their cash—and no one knows when interest rates will rise. “If the Fed doesn’t move rates for a while, there could be opportunity cost if you choose to invest in the shortest and most liquid securities,” says Sharpe.
Again, consider your need for cash. 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 0.2% 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 0.40% and 0.50% 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 cash stake 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 three-, six-, nine-, and 12-month maturities.
“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 Brokerage Product. “This means that as of April 9, a three-month Treasury bill offered a 0.07% yield, a two-year Treasury note yielded 0.33%, and a two-year CD as much as 0.75%.2 That is a significant differential. Providing you are comfortable with the staging of your maturities and have enough cash on hand to meet your needs, you can allow the investments to mature at par, 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 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.
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