Where to Earn More on your Cash
As stock markets continue to decline -- about 10 percent so far in 2008 -- and investors see the value of their portfolios fall, many folks are beating a path to the sidelines. According to Trim Tabs Investment Research, all equity mutual funds posted outflows of over $12 billion for the week ending Wednesday, January 9, a $2 billion increase in outflows over the previous week. Outflows from exchange-traded funds that invest in U.S. stocks were about $8 billion for the same week.
Parking Cash in Money Market Funds
Much of this cash from selling stock funds is ending up in money market funds. Last week, assets in taxable money market funds rose to a record $2.68 trillion, and assets in tax-exempt money funds rose to a record $483 billion -- that's over $3.1 trillion in money market funds, according to the Investment Company Institute.
All this cash flowing into money market funds may be a sign that investors, nervous about the prospects of a long-term falling stock market, are heading to the sidelines in an effort to preserve the value of their portfolios. Another way to read this is that these investors are staying liquid and flexible, keeping cash in their investment accounts ready to put to work when an oversold market begins to recover.
Whatever the situation, investors with lots of cash right now need to seek the best return ON their money. But in doing so, there are risks: Some folks who have strayed from the typical money market fund to other so-called "safe investments" as they searched for higher yields have been burned. Some money market funds have been reported to have closed due to a high volume of investor outflows, which makes it difficult for the funds' managers to sell the underlying investments for full value.
Also, some "ultra-short-term" bond funds have fallen as much as eight percent in value because, to the shock of their investors, the funds owned securities tied to defaulting subprime mortgages.
The bottom line is that folks need to know what can go wrong with any investment they make, and in doing so, need to be equally focused on the return OF their money. Here is a rundown of a few of the options for getting the best return on -- and of -- your cash:
Money Market Funds
There are about 827 money market funds, and these hold about 22 percent of all mutual fund assets. They are regulated by the U.S. Securities and Exchange Commission and are managed with the goal of maintaining a stable share value of $1 for all purchases and withdrawals.
Money market funds hold short-term debt instruments, such as Treasury bills, commercial paper, certificates of deposit, etc. with maturities averaging about 90 days. Because of the short maturities and generally liquid nature of these securities, it is rare for a money market fund to "break the buck" -- industry speak for falling below $1 a share, when investors would lose some of their money. When this has happened, the managers of the funds have usually stepped in and supported the $1 price with their own cash reserves, but this has not always been the case. For this reason, investors who keep large amounts of cash in money market funds are advised to use only funds managed by firms that are financially sound, with strong balance sheets.
Most money market funds allow daily withdrawals and are typically tied to banking and investment accounts. Money market funds are typically not FDIC insured, but rather are treated as securities, and therefore investors are protected by the Securities Investor Protection Corporation, or SIPC.
Unlike FDIC protections, SIPC does not provide blanket protection for losses. The purpose of SIPC protection is to replace securities that are missing when a brokerage firm fails. It does not make up for lost market value while missing or for losses due to bad investment advice. Under SIPC, both cash and securities are covered, with a limit of $500,000 for securities and $100,000 for missing cash.
According to iMoneyNet, the average yield for taxable money market funds is 3.96 percent and about 2.6 percent for tax-free money funds. But with a little effort and time, folks can find money market funds with taxable yields of up to five percent, using Web sites such as www.money-rate.com and www.bankrate.com.
If you are subject to a higher tax bracket, consider a tax-exempt money market fund. Although the yields are lower, they pay more after taxes are taken from taxable money fund yields.
Finally, ask your bank or brokerage firm if their money market fund compounds interest daily, monthly or quarterly. Daily compounding - where you earn interest on each day's interest - produces a higher yield. Surprisingly, some 30 percent of money funds still only compound monthly or quarterly.
Auction Rate Resets
These are tax-exempt funds that provide higher yields than money market funds, but only allow investors to buy or redeem shares on a set schedule -- typically every seven, 14, 28 or 35 days. These so-called money market alternatives are professionally managed funds that own underlying bonds with maturities of between five and 30 years. Investors are assured that the price per share will be maintained at $1 and the rate of return is reset each time the fund is open to new purchases or withdrawals. The safest resets are the seven day variety, since investors are given the opportunity to redeem shares one each week. Tax-exempt yields can range from 3.9-to-five percent, depending on the underlying investments and issuer. Since tax-exempt resets typically own insured municipal bonds and they do not invest in mortgages, they are viewed as relatively safe, but there is no guarantee that you will never have a loss.
Certificates of Deposit
Certificates of Deposit are typically issued by banks and are usually backed by FDIC insurance, providing investors with blanket protection of up to $100,000 per account and up to $250,000 in retirement accounts, against losses if the underlying bank fails. So if a regulator closed down a bank, the FDIC would immediately pay off insured deposits, usually by transferring balances to another bank overnight.
It's important to know how the $100,000 per account rules for FDIC protection work, so you can maximize the FDIC protection over more of your deposits and CDs. For example, a husband and wife can each have $100,000 in accounts separately titled in their names, another $200,000 in an account titled jointly, and each have up to $250,000 in their own IRA. Then, all assets totaling $900,000 in these five accounts, even at the same bank, would receive FDIC protection.
With the Fed lowering short-term interest rates, yields on money market funds have slipped and are likely to continue to fall. But CD yields have fallen by a very small amount, since banks that need to attract deposits to boost their reserves and back their loans view paying higher rates on CDs to depositors as a lower cost of borrowed money for them. Investors seeking safe havens for their cash for awhile are advised to consider locking into yields on one-year CDs, where you can still lock into rates of up to five percent. But when you do this, make sure to ask if there are any fees for redeeming a CD before its date of maturity. Typically, there is a penalty of forfeiting up to three months of interest if you do that.
A lot of folks think they need to open an account at a bank to buy a CD, but that is not true. At many brokerage firms, you can also by FDIC-insured CDs right in the same account where you have your money market funds, stocks and bonds. Ask your brokerage firm to tell you about its supply of newly-issued CDs, and ask what is available on the resale or secondary market. Currently, you should be able to find one-year CDs with rates of five-to-5.25 percent. Also, search sites such as www.bankrate.com , www.money-rate.com and www.quicken.com for some of the highest yielding CDs available.
Treasury Bills, Notes and "TIPS"
With the backdrop of the subprime mortgage crisis, write-downs by large financial firms, and a faltering US economy and stock market, some investors' ultimate concern may be the return of their money. If you are in this category, then the safest investment is U.S. Treasury bills. Treasury bills, also called T-bills, are sold in maturities ranging from a few days to 26 weeks. T-bills are sold at a discount from their face value so, for example, if you buy a six month T-bill for $986, you will receive $1000 when it matures. The difference between the purchase price and the amount you receive at maturity is the interest.
Treasury notes, sometimes called T-Notes, are issued with maturities of two, five and 10 years and earn a fixed rate of interest every six months until maturity.
Investors concerned about rising inflation can purchase Treasury Inflation Protected Securities, or TIPS, which pay interest semi-annually with a rate tied to the increase in the CPI-U inflation index. Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. So, as inflation rises, every six months your TIPS will also increase by the stated rate of inflation. You also will get an additional, fixed rate of interest on your TIPS, which is paid every six months.
Because Treasuries are guaranteed by the full faith and credit of the U.S. government, they are considered the safest investments. For this reason, the yields are low. The current yield on the 26-week T-bill is about 2.7 percent -- more than the yield on the two year T-note, so it would not be advised to lock into two-to-five-year, longer-term treasuries at this time.
T-Bills, T-Notes and TIPS can be purchased in increments of $1000 and are available at most brokerage firms, or directly from the U.S. Treasury if you open a Treasury Direct account. To learn more, the best site to check out is www.treasurydirect.gov.