Cash, often an afterthought in the investment world, has started to come up frequently in client conversations because, for the first time in a while, you can earn decent interest on your cash holdings. Cash and cash alternatives typically have very short-term interest rates tied to the Federal Reserve’s rate, which can change rapidly. Just because you’re learning 4% today doesn’t mean you will earn that much one month from now. This is called reinvestment risk.
A few options to consider, ranging from highly liquid to longer-term and locked up, are listed below with their pros and cons. Proper cash management likely combines a variety of these techniques.
1. High Yield Savings – This is the most liquid form of cash and can carry enticing interest rates. These accounts are susceptible to interest rate risk and you should be mindful of FDIC deposit insurance limits. It’s also important to note that there may be restrictions on moving money in and out of your account.
2. Bank CDs – Most of us are familiar with bank CDs which you can buy at your bank. They provide FDIC insurance, but are also subject to whatever the bank would like to pay. Some banks may not be providing the best rate for your money. Also, these are usually very illiquid and while you can access your funds before the CD matures you may pay a penalty to do so. You are guaranteed whatever interest is listed on the CD so you don’t have reinvestment risk for the term of the CD. There may be limited options on the term (in other words they may not offer a 24 month CD).
3. Brokered CDs/Treasuries – Brokered CDs are CDs that are bought in a brokerage account and have FDIC insurance. These will provide whatever the market rate is at the time and can in some cases be much higher than a bank CD. Because there are many types of CDs available, you can tailor the CD to your exact needs. Treasuries are similar in that there are many terms and types, and can be bought at any time. With either investment you can sell them early if you need to, but you may have a gain or loss. Depending on how you buy them there may be additional costs or fees. There are other client specific features such as tax benefits and the ability to put back a bond that should be discussed on a situational basis.
4. Money Market Funds – These are mutual funds that make investments in short maturity bonds with high current rates which have subsequent reinvestment risk. They may pay slightly higher than bank accounts but often charge a small expense to run the fund. It’s important to remember these are investments and in times of extreme stress can lose value. They can often be sold within a day and give ready access to your funds.
5. Short-term Municipal Bonds – For clients who are in higher tax brackets or high tax states, owning short-term municipal bonds can help provide lower or tax-free income while allowing them the liquidity of selling the investment if needed. Similar to treasuries these investments may have extra costs that impact their return and may experience a gain or loss if sold early.
6. Fixed Annuities – For clients looking to lock in a rate and do not need access to their funds or FDIC insurance, fixed annuities can be a viable alternative. Rates are likely higher than a bank CD and gains are tax deferred. There are often costs for early surrender and may be tax penalties if you withdraw before 59½ years old so they should be viewed as a longer-term investment.
When we advise clients on their financial plan, we often recommend they hold 12-18 months of cash. You may be able to combine these options in a way that increases your interest while giving you liquidity.