Where's the Best Place to Park Your Cash?
Yields are going up, but be sure to mind liquidity, safety, and tax issues.
Not so long ago, one cash investment seemed virtually indistinguishable from the next. With the Fed funds rate barely positive as recently as late 2016, most investors considered their low-yielding CDs and money market funds dead money--a necessary parking place for near-term expenditures, or a place to hunker down if they were feeling fearful. Nothing more.
Yet thanks to the Federal Reserve's efforts to normalize interest rates, cash yields have been steadily rising. It would be a stretch to suggest that cash is going to be a return engine any time soon, as you're lucky to earn more than 2% on any sort of cash instrument today. But as yields have risen, we're starting to see greater yield differentiation among various cash vehicles. Just a few years ago, FDIC-insured online savings accounts were in many cases yielding more than non-FDIC-insured money market mutual funds, providing an arbitrage opportunity for opportunistic investors. Now, however, a more traditional relationship between risk and yield prevails; you're going to earn the highest yields by being willing to put up with some liquidity constraints and/or venturing into non-FDIC-insured investment types.
Here are some of the key factors to consider to help home in on the right cash instruments for you.
If You Prize Safety Above All
If you would like an ironclad guarantee against loss, it's wise to focus on those that are backed by the Federal Deposit Insurance Corporation. Such accounts provide the assurance that you'll be made whole if your account has a loss; FDIC insurance covers up to $250,000 per depositor per institution. On the short list of FDIC-insured investments include checking and savings accounts, CDs, money market accounts (not to be confused with money market mutual funds), and online savings accounts. Brokerage sweep accounts, which often offer paltry yields in exchange for the convenience of having your dough readily accessible for investing in your mutual fund or brokerage account, may also be FDIC-insured, depending on whether your money is being swept into a bank account or a money market mutual fund.
Not on the list: money market mutual funds, or any mutual funds, for that matter. While money market fund yields have edged above FDIC-insured investments in many cases, these products are not FDIC-insured. That said, regulations that went into effect in 2016 tightened up the rules for money market mutual fund management, making a repeat of the Reserve Primary fund debacle unlikely. The new regulations also carry caveats for investors: As of 2016, prime and municipal money market funds--both retail and institutional--are required to impose redemption fees and install "gates" when liquidity has dropped below certain levels, in an effort to stem high redemptions in periods of market duress. Government-focused money market funds for both institutional and retail investors are not required to impose fees or install redemption gates, but they can do so at the discretion of their boards. Government-focused money market funds are the safest money market mutual funds, as they invest virtually all of their assets in government-issued securities--from a practical standpoint, they're very safe, even if they're not FDIC-insured. The trade-off is that their yields are typically lower than nongovernment money market mutual funds.
Demand notes issued by corporations are another type of cash alternative that are not FDIC-insured. Their yields are often quite attractive relative to cash investments with FDIC backing; for example, GM "Right Notes" currently offer yields of more than 2%. The trade-off is that, in contrast with, say, a money market mutual fund that owns a basket of debt obligations from various issuers, demand notes are issued by a single corporation and therefore don't offer diversification. Jason Zweig assessed the risk of demand notes in this article.
If You Prize Safety, a Higher Yield, and Don't Need Liquidity
If you prize safety, seek a decent yield, and don't need ongoing access to your funds, CDs are a good bet. Right now, for example, you can readily find one-year CDs that are yielding 2.5%; three-year and five-year CD yields have edged above 3%--in line with the yield on the Bloomberg Barclays Aggregate Index. With the prospect of yields heading higher, creating a simple CD ladder can be an attractive strategy. With a basic CD ladder, you'd segment your cash into five equal parts and purchase one-, two-, three-, four-, and five-year CD with each component. Creating a CD ladder can help ensure that you can take advantage of higher yields when and if they come online.
If You Prize Safety and Need Liquidity
If you're seeking the safety of FDIC protection and need regular access to your funds, CDs won't cut it; you'll be on the hook for a penalty if you need to gain access to the money in a CD prior to the CD maturing. Instead, you have a few key options: a savings account or a money market account offered through a bank (bricks and mortar or online) or a credit union. You might also consider a money market mutual fund; just bear in mind the lack of FDIC protections, as discussed above.
Among the account types with FDIC protections, such as savings accounts or money market accounts, the key difference will tend to be how readily you can access your cash. Money market accounts typically feature check-writing privileges; savings accounts won't always do so, though some do. Also be aware that both account types are governed by a Federal Reserve Board rule called Regulation D, which places limits on the number of transactions you can conduct in such accounts each month.
Finally, be sure to read the fine print. The accounts with the highest yields typically require you to maintain a minimum balance; attractive "teaser" rates may also apply to the first few months you hold the account, but drop after that.
If You're in a High Tax Bracket
With cash yields as low as they have been, it has been hard to get excited about the taxes you'll owe on any income you receive from those accounts, even if that income is dunned at your ordinary income tax rate. But now that yields are heading higher, the tax effects of sizable cash allocations can be more meaningful, at least in real-dollar terms. Investors in higher tax brackets should consider a municipal money market mutual fund, which invests in the short-term obligations of various municipalities. Such funds pay income that's generally free from federal tax; if you buy a muni money market fund dedicated to the state in which you live, your income distributions will also escape state tax, too. Right now, for example, Vanguard’s Municipal Money Market Fund VMSXX is yielding 1.2%, versus 1.8% for Vanguard Federal Money Market. That means that you'd need to be in the 35% tax bracket or above for the muni fund to be the higher-yielding option. Before venturing into a municipal money market fund, be sure you understand the rules that would apply in case of a liquidity shock, as discussed here.
If Cash Is Part of Your Long-Term Asset Allocation
If you're holding cash as part of your strategic asset allocation, rather than because you need ongoing access to your funds, you might consider using a stable-value fund to wring a higher yield from your cash. Stable-value funds, which are only accessible inside of company retirement plans, will typically yield more than the money market fund on offer inside your plan. To do so, they invest in bonds, so they're not FDIC-insured; to protect investors' principal, they employ insurance wrappers to help maintain a stable net asset value.
Just bear in mind that stable-value funds carry drawbacks. Because you can only own such a fund within a 401(k), you'll pay taxes and penalties to withdraw your money prior to retirement unless you meet certain criteria. In other words, don't think of a stable-value fund as a liquidity source unless you're already retired or close to it. Second, even though stable-value funds buy insurance wrappers to help protect investors' principal, the assets aren't guaranteed or eligible for FDIC protections.