Where should you put your rainy-day fund?
A low-risk piece of paper from the U.S. Treasury yields 2.8%. You’re probably not getting anything like that on the cash you have sitting in a bank.
What follows is an instruction manual on extracting the most from uninvested cash. We’ll look at money funds, CDs, bond ETFs, terminating ETFs and Treasury notes. Some of these options entail a bit of risk. All of them offer better returns than the stingy amounts paid on checking accounts.
These days the yield curve is rather flat, which is another way of saying that you don’t get a particularly rich reward for stretching out the maturity of your fixed-income portfolio and taking the risk that rates will rise. So, there is much to be said for parking your cash in a money-market fund. You’ll be at the low end of the yield curve but you won’t be taking chances.
Vanguard’s Prime money fund, which has $112 billion of customers’ money, is one of the better ones. It yields 2.3% after Vanguard skims off 0.16% ($16 annually per $10,000) for overhead. Its holdings are of very high credit quality and very short maturity, roughly one month.
The tricky business is attaching a money market fund to your transaction account (where you receive direct deposits and disburse electronic payments). If you do your banking at Vanguard, that’s a simple task. If you do your banking at a commercial bank, it’s not. I explore ways to optimize your transaction account in Get More Yield On Your Cash.
Certificates of deposit
A conservative place in which to park cash for one to five years is a bank CD. Interest-rate risk is low because, if rates skyrocket and you want to start over, you can back out of the deal by sacrificing some accrued interest. Default risk is close to zero because you are protected by federal deposit insurance (if you observe certain limits). Liquidity is okay.
Allan Roth, a Colorado Springs, Colorado financial planner, has made juggling CDs into an art form for himself and his clients. I hesitate for only one reason: I’m afraid I’ll lose track of an account. It would be like forgetting the password to a bitcoin.
Short-term bond funds
You can stash your rainy-day kitty in an exchange-traded fund that owns short-term bonds, those due in three years or less. One that I like is Schwab Short-Term U.S. Treasury (ticker: SCHO), with a bargain 0.06% expense ratio (that’s $6 a year per $10,000) and a two-year duration.
The duration number means that this fund has as much interest-rate risk as a Treasury zero due in two years. If rates shoot up one percentage point overnight, you’re out 2%. Tolerable? I think so. Rates have been moving, and the $50 share price has indeed swung by a dollar or so over the past year.
The schoolmarms of personal finance are aghast. Emergency cash should be in cash, they say. What if you need $10,000 for hurricane repairs? Your SCHO might be down. You might have to sell at a loss.
Well, yeah. You might have to sell at a gain, too. The fund’s price could just as easily go up a dollar.
Put this in context. Suzy Creamcheese has, let us say, $500,000 in stocks inherited from her aunt, $500,000 in long-term bonds in her 401(k) and $20,000 in emergency savings. If stocks lurch down, she’s out $200,000 before she knows it. If rates shoot up, her retirement account gets clipped for $60,000. So what if her emergency account takes a $400 hit?
It is often opined that you need to have six months of spending in cash. I disagree. You don’t need cash, you need liquidity. An ETF can supply it. Put in a sell order for SCHO and you get cash two days later. Better still, own the fund in a margin account, and in a pinch you can get cash sooner by taking out a margin loan while you’re waiting for the trade to settle.
The table displays 11 ETFs worth your attention. They all run up fees of $10 or less annually per $10,000 invested. You can pick your risk level. In comparison with an ultrasafe money market fund, the riskiest of the bunch tack on roughly 1.2 percentage points of expected return while exposing you to both corporate defaults and rising rates. If that’s scary, go half way toward the risk corner.
A note on costs: With a checking account or money fund, you have no transaction costs. With ETFs you have at least one, the bid/ask spread, often a penny or two per share. Thus, on a $20,000 trade in a $50 bond fund, you might give up $8, round-trip, to the market makers. The other potential cost is two brokerage commissions. They might run you $5 each or they might be free of charge. (Shop around.)
Don’t let $18 in transaction costs stop you from getting $560 a year in interest.
Some ETFs have ending dates. They own only bonds maturing in, say, 2021, at which point they liquidate. The table above includes sample funds from both Invesco and BlackRock’s iShares division; there are many more to choose from, with different dates and different kinds of portfolios (just corporates, for example, or just emerging market govvies).
This sort of self-destruct ETF will be appealing to investors targeting a particular outlay. If you’re funding a tuition bill due in 2021, you could buy a 2021 ETF. If interest rates go haywire and the share price moves you will shrug, because you know your bonds are going back to par when you need the money. Your only risk is that of losing principal to defaults.
The nice thing about living in a nation that is in the hole is having plenty of Treasury paper to pick through. I see on Fidelity’s bond page that the 2-3/4s of September 30, 2020 were recently trading at 99.851 bid, 99.870 ask. Big investors were giving up to the middlemen only $19 per $100,000 invested, round trip.
As for little people: The ask price for this particular bond was available on purchases as small as 25 bonds, which is to say $25,000 of par value. If you want to set aside that kind of money for a little less than two years, this looks like a good spot.
If you hold to maturity you can view the frictional cost of a bond position as only half the bid/ask spread. That means your yield give-up to the middlemen in the case cited would have been half a basis point (50 cents lost per year per $10,000). That’s way less than the holding cost on any bond fund.
What about an emergency? You visit Santa Monica and get arrested for using a plastic straw. To raise bail, you can sell the T note. In this particular case you won’t qualify for the quoted bid unless you’re unloading at least 250 bonds, but a 25-bond order would probably still get fairly good execution.
Yield on this bond is 2.8%. Betcha that’s more than your bank is paying on checking.