Safe Places to Stash Cash in an Uncertain World

Published December 14, 2011

| Bankrate.com

Investors have many options when the return of principal is more important than the return on principal. But in today's ultra-low yield environment, the price of safety is enormous.

That's why savers and investors may need to abandon the idea that one magic bullet will meet their needs. Instead, they should adopt a diversified, shotgun approach as they target safe investments.

By combining investments with different risk and return profiles, savers can avoid losing purchasing power to inflation while keeping their principal protected for the most part.

"The takeaway here is: Avoid negative real returns. That should be a fundamental. People are lining up for zero or negative numbers," says William Larkin, portfolio manager at Cabot Money Management in Salem, Mass. A real rate of return factors inflation into the equation.

The second takeaway, says Larkin, is to diversify. Diversification can reduce volatility and increase returns, but individual needs will vary. A person saving money for one year will have greatly different needs from someone with three to five years -- or even longer -- before they need to tap into their savings.

Before buying any investment, "try to understand what your issue is," says Herbert Hopwood, CFP, president of Hopwood Financial in Great Falls, Va. "I don't think there is a one-size-fits-all. It depends on the person."

CDs Preserve Principal but Offer low Yields

What they are

Certificates of deposit are like the offspring of bonds and savings accounts. CDs are issued by banks or credit unions. They're insured by the Federal Deposit Insurance Corp. or the credit union equivalent known as the National Credit Union Administration. Like bonds, they sport a coupon, or interest rate, and a maturity date.

The interest rate will typically be slightly higher than that of a savings account due to the time element on a CD.

How they work

Certificates of deposit are also called time deposits; you give the bank your money and they pay you a fixed rate of return for a specified amount of time. At the end of the term, you get your money back plus interest.

If you need to access your money before the CD matures, you will likely be hit with an early withdrawal penalty.

Advantages and disadvantages

Unlike many investments, CDs are easy to understand and they're extremely accessible. Anyone can walk into a bank and buy one. They are also extremely safe. There are two ways to lose money in a CD: through a bank default or an early withdrawal.

Because most CDs issued by American banks are insured by the FDIC or NCUA, CD investors can rest assured their CDs are protected from a bank failure -- for up to $250,000.

An early withdrawal by the investor is much more likely to occur than a bank failure, even these days. Savers should investigate the early withdrawal penalty before investing their savings. It could cost more to break the CD than the investment would have ever earned in interest.

Warning

CDs are great for short-term savings or as part of an overall strategy. What makes them unattractive, despite their safety, is the low yield. In today's rate environment CD rates are no match for inflation.

Just to keep up with an inflation rate of 2 percent, $100 invested in a five-year CD today would need to earn about $10.

According to a recent rate survey by Bankrate, the average five-year CD yield is 1.19 percent. An investor would gain $6.09 after five years on a $100 investment.

"For short-term savings, a CD is very appropriate. But I don't think a CD is a very productive long-term investment at all," says Lance Scott, president of Bay Harbor Wealth Management in Baltimore.

"A lot of older investors find themselves in the CD trap. They will be in a CD for a short period of time, and then before they know it they've rolled it over for years," Scott says.

However, some yield is better than nothing. Investors may find it more worthwhile to take the paltry yield on a one- or two-year CD over staying in cash for a portion of their portfolio.

Hopwood suggests keeping some money in CDs "just because there is a penalty for keeping it in cash right now -- cash is basically yielding zero."

Money Market Mutual Funds a Lackluster Haven

What they are

Money market mutual funds are similar to money market accounts, but money market funds are not insured by the Federal Deposit Insurance Corp. They tend to be a little riskier than their bank counterparts, and that is reflected in the rate.

Money market funds nearly always maintain a $1 per share net asset value, but that rule has sometimes been broken. Following the collapse of Lehman Brothers in 2008, the share price of one money market fund dipped below $1. To avoid breaking the buck, 62 others had to be propped up by their parent companies, according to a report from Moody's in 2010.

How they work

Money market funds hold high-quality, short-term debt securities such as Treasury bills. They're required to hold a certain amount of cash or cash equivalents in order to maintain a certain level of liquidity.

But not all money market mutual funds are the same. Some invest in municipal bonds and offer a little yield exempt from federal income tax, while others yield virtually nothing -- at least these days -- but do provide a safe place to hold money. Examples of the types of investments money market funds hold are Treasuries, certificates of deposit, commercial paper and debt securities issued by foreign banks.

Advantages and disadvantages

In a more normal interest rate environment, money market funds may offer yields that are comparable to less liquid investments such as CDs.

Though money market funds offer better liquidity, they could potentially lose money, though the likelihood is remote. According to the Investment Company Institute, the mutual fund industry trade association, four factors could cause a deviation from the $1 net asset value.

  • Changes in interest rates.
  • The maturity of the fund's portfolio.
  • Lots of money flowing in and out.
  • Credit events affecting securities held in the fund.

Many money market funds invest in foreign bank obligations, and many European banks hold sovereign debt from the imperiled Portugal, Italy, Ireland, Greece and Spain -- notably Greece. A Greek default on sovereign debt could potentially spiral down to American money market funds, but domestic money market funds have been reducing their exposure to European banks in recent months.

In October, Fitch Ratings reported European bank holdings account for 37.7 percent of the 10 largest U.S. prime money market funds.

Warning

Though the possibility of losing money in a money market fund exists, a more salient concern is the erosion of purchasing power by inflation.

"There is about $2.6 trillion in money market funds that's actually losing money every single year in terms of its inflation-adjusted purchasing power, which is the object of keeping money in bonds," says Larkin. "So people are putting up red ink every year, but they don't see it. They feel good, but the price doesn't move. And that is a huge trap."

Municipal Bonds Attractive as a Tax Haven

What they are

Municipal bonds are debt securities issued by governments in states, cities, counties and towns. They are particularly appealing to investors because of their tax-exempt status. The interest earned on most muni bonds is free from federal taxes and, in some cases, state and local taxes as well.

How they work

Municipal bonds are securities that represent a loan by investors to the issuer. Just like a CD, the issuer pays a coupon, or a stated amount of interest, for a set period of time, known as the maturity.

The bond may fluctuate in value throughout its life. Investors who hold a bond until maturity, however, will get their full investment back in most cases. In the rare event the issuer defaults, investors may get all, some or none of their money back.

Advantages and disadvantages

The advantages of municipal bonds are in their tax-exempt yield. They appeal to investors looking for ways to limit the amount of income tax they pay, and they can end up actually yielding more than taxable bonds once the tax break is considered.

On the downside, some local governments are stronger than others, and the 2008 financial crisis exposed some of the weaker states and cities. Before buying a municipal bond, investors should investigate the credit quality of the issuer.

Considerations

If the possibility of defaults has you leery of investing in municipal debt, consider pre-refunded or escrowed-to-maturity municipal bonds.

"In the muni bond market, both taxable and tax exempt on the pre-re and escrow side still give good yields," says Donald Cummings, founder and portfolio manager at Blue Haven Capital in Geneva, Ill.

Pre-refunded and escrowed-to-maturity municipal bonds are typically backed by investments in U.S. Treasuries and are considered fairly safe.

Here's how they work in a nutshell: A municipal bond issuer may decide it wants to refund a bond that investors already hold. Why? The bond may be too expensive or have unfavorable terms the issuer wants to shed.

It can issue a new bond and take the proceeds from selling it to buy Treasury securities, which are placed into an escrow account. Instead of Treasuries, they may buy Fannie Maes or Freddie Macs or other securities. The interest payments from the securities then go to pay interest on the outstanding old bonds.

In most cases, investors with bonds that are escrowed-to-maturity will continue to receive payments from the collateralized securities until their bonds mature. However, in some instances the bonds may be called early.

Investors of pre-refunded bonds will receive payments until the call date, at which point the bonds are called back and redeemed with the funds from the escrowed accounts.

With both the pre-refunded or escrowed bonds, the escrow account is used to pay both principal and interest.

Bond Funds Come in All Types and Risk Levels

What they are

Bond funds are mutual funds that invest exclusively in debt issued by corporations, governments, government-sponsored enterprises or government agencies.

They typically follow a certain investment objective while sticking with a minimum credit quality and similar maturities. The maturities may not be exactly the same; they may span a range. For instance, short-term bond funds may hold issues with maturities ranging from one to three years.

How they work

Like equity mutual funds, bond funds can be narrowly focused on high-quality, safe investments or they can be all over the map, pulling in bonds from emerging markets, asset-backed securities, high-yield and investment-grade corporate bonds.

Advantages and disadvantages

Investors who would otherwise have a difficult time entering the bond market get professional management of a diverse set of fixed-income securities. The disadvantage is that fund managers can buy and sell securities without holding them to maturity, so investors have little protection against interest rate risk.

When the Federal Reserve increases interest rates, then the price of existing bonds drops. This doesn't bode well for bonds held in mutual funds. The value of those bonds drops as interest rates rise, so the value of the mutual fund as a whole also declines.

Today's uncertain rate environment points to the need to stay toward the short end of the yield curve, as longer-dated bonds will be more impacted by interest rate increases.

"We should be essentially medium-term on average in the bond funds we use, and as interest rates rise we should be ready to shorten that up even further," says Robert Fragasso, CFP, chairman and CEO of Fragasso Financial Advisors in Pittsburgh.

Warning

For the past 30 years, bonds have enjoyed a great run, but experts predict that a change may be on the horizon.

"I'm avoiding anything with a government guarantee because the central bank is buying that debt and artificially pushing those (yields) down," says Larkin.

The yields are too low on mortgage-backed securities, U.S. agencies and U.S. Treasuries. In a 5 percent inflation environment, things could change very abruptly, and some of the losses could be quite substantial, he says.

For investors who cannot risk losing any principal, Larkin suggests earning close to zero is preferable to investing in bond funds.

"The risks are rising that the change might be coming," he says.

Considerations

For a small portion of their fixed-income portfolio, investors may want to consider bond funds with an unrestrained strategy -- they typically fall into the Morningstar category of multisector bond funds. These funds go further afield than a traditional bond fund, picking up currencies and derivatives such as futures contracts and swap agreements. Plus they hold bonds of varying credit quality from corporations in the U.S., foreign countries and emerging markets.

"They can go do whatever they want. So you're letting someone very, very skilled at the markets go and find the best value," says Larkin.

Using one of these funds for a piece of your portfolio could add some diversity and let professionals do the legwork.

 

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