CDs and short-duration bonds may offer higher yields but more risk than savings accounts.
As of mid-January, standard rates on savings accounts at the nation’s largest banks were around 0.01% to 0.03%.1 That’s not nothing, but it sure is close.
The bad news for savers is that there isn’t a lot of yield to be found, at least not from investments that are safe enough to be considered as a home for your cash. But even if you can’t earn a lot on your cash, that doesn’t mean you can’t do significantly better.
“There are a range of income options that can offer a meaningful increase in income; you could potentially increase the yield on your savings by a significant amount,” says Richard Carter. “The key is to understand what you need the money for, and then find an option that makes sense for your situation.”
First consider your goals
Before you look for higher-yielding options, take a second to reconsider the role of your cash in your financial plan.
There was a lot of noise in the investment markets around rising rates last year, but for investors with a lot of cash, the story was pretty much the same: paltry yields on bank accounts and money market funds. With interest rates so low, you may have wondered whether you should just stuff your cash under a mattress.
But while finding yield in the short-term market has been challenging, it isn't impossible. You may be able to boost the income your cash allocation produces—but the downside is that you have to take on greater risk.
To determine whether it makes sense to accept greater risk in exchange for greater yield potential, consider the purpose for your cash investments. In some cases, you may require absolute stability, but in others you may be willing to accept some possibility of declines in exchange for higher interest payments. The decision comes down to your needs: the role this allocation plays in your overall portfolio, and what you hope to get out of it given your needs and time horizon.
Low yields explained
In December 2008, the Federal Reserve cut the target federal funds rate—a key benchmark for short-term interest rates—to a record-low range from 0.00% to 0.25%. The Fed’s goal was to help pull the U.S. economy out of a deep recession and financial crisis.
The low federal funds rate has acted as an anchor on yields offered by short-term instruments such as Treasury bills, deposit and savings accounts, money market funds, and other short-term bond funds. The average taxable money market fund paid a seven-day yield of just 0.02% as of June 23, 2015, according to money fund tracker iMoneyNet, while yields on Treasury bills with maturities of three months or shorter hovered below 0.05%, and have even dipped into negative territory, at times, during the past five years, when nervous investors flocked to the highest-quality securities.
Digging into risk
Some shorter-term investment options offer significantly more yield than money funds and T-bills, but generally have either lower credit ratings or longer maturities than the securities that make up traditional short-term holdings. Those characteristics make the securities more vulnerable to declines, so you may need to be able to stomach minor downturns in your principal value, depending on the use you have in mind for your money. In general, most investors manage the risk level of their portfolios by making decisions about the equity allocation or fixed income allocation. But to a lesser extent, you can make these same choices within the short-term portion of your portfolio.
Bear in mind the following risks when determining whether to pursue higher yield with a portion of your cash allocation.
Credit risk
Corporate bonds pay significantly more yield than Treasuries, to compensate for the greater risk that the issuer will default. The greater the expected risk, the larger the yield premium a corporate bond or bill offers compared with a Treasury with a comparable term.
| More credit risk may mean more yield | Yield | |||||||||
| Higher credit quality | Government-backed 3-month Treasury bills | 0.02% | ||||||||
| Lower credit quality | Investment-grade 3-month corporate paper (financial) | 0.85% | ||||||||
| Data as of 6/17/15. Source: Fidelity.com
Whether it makes sense to reach for yield by extending further down to weaker credit ratings—and how far it makes sense to reach—depends largely on how you intend to use your investments. If you need the money for everyday expenses, you probably can’t abide any fluctuation in the value of your principal, so you may want to consider a money market fund, one of the lowest-risk investment options.1
On the other hand, you may be able to tolerate the occasional blip in your account balance—for example, when investing the cash allocation of a long-term portfolio or a portion of your emergency fund. In that case, you may want to hold a portion of your cash in higher-yielding securities.
If you do want to invest in lower-rated securities, it is important to remember that lower credit ratings usually indicate a weaker balance sheet and a higher risk of bankruptcy for bondholders. So it is important to perform research on the underlying company and the specific features of an individual bond—or you could invest in a bond fund to tap into professional research and management capabilities.
Interest rate risk
Another way to secure higher yields is to hold securities with longer terms. In general, when two bonds with comparable credit ratings have different maturity dates, the one with the longer term will typically pay more yield, and be more sensitive to interest rate changes.
Investors chart the different yields offered by bonds with various maturities on a graph called the yield curve. The graph recently looked like the chart to the right.
Fixed income investors refer to the difference between the yield of longer- and shorter-maturity bonds as the steepness of the yield curve. When the yield curve is steep, it means that you can earn more income by investing in longer-maturity bonds. The same principle holds true for different maturities on the shorter end of the curve: Typically, a longer-maturity bond will offer more yield than a shorter-maturity bond, even if you are comparing one- and three-month bonds or one- and three-year bonds.
The trouble is that longer-term bonds carry greater interest rate risk: If the general level of interest rates rises, bond prices will usually fall—and they’ll fall further for longer-term bonds than for shorter-term bonds.
A bond’s sensitivity to interest rate changes is expressed by its duration (technically, the weighted average time until the bond’s future payments). As a rule of thumb, an investment-grade security with duration of 1.9 could be expected to lose approximately 1.9% each time interest rates rise by 1%. Likewise, it could gain 1.9% when interest rates drop by 1%.
Considering that interest rates are hovering at or near their historic lows, they have much more room to go up than down, causing many investors to worry about potential interest rate risk. Some investors are limiting their holdings to very short-term securities to limit the damage from any interest rate hikes. But these investors are earning little to no yield on such securities—and while the Fed has announced that it is considering raising rates in 2015 or 2016, not one knows exactly when, or by how much, rates could rise.
Again, consider your need for cash. If you are looking for the least risk, keep your money in a money market, savings, or checking account. If you do use one of these accounts, look for higher introductory interest rates that may be available, and watch out for ATM surcharges, minimum balance fees, and other charges. If you can handle a decline in your principal, you may want to hold a portion of your allocation in longer-term securities.
According to Kim Miller, manager of Fidelity® Conservative Income Bond Fund (FCONX), "An investor in a money market fund is probably earning between 0.01% and 0.10% right now. The yield curve changes daily, of course, but an investor willing to take on a little more price risk and principal volatility—less than a typical short- to intermediate-term bond fund might offer—could pick up between 0.20% and 0.30% in yield for some of their short-term assets by moving out the curve marginally, to a duration of three to six months."
In that case, you might consider shifting part of your short-term allocation to an ultra-short- or short-term bond fund. Or, if you prefer to invest through individual issues, you may want to build a ladder of bonds or CDs with sequential maturity dates—for example, holding equal amounts in securities with 6-, 12-, 24-, and 36-month maturities. If you do prefer to invest in individual securities, keep in mind that transaction costs will reduce yields, and you may need significant assets to buy enough bonds to build a diversified ladder.
Find up to date yield data
"Despite low levels of absolute yields, the yield curve—which shows the difference between long- and short-term interest rates—is still moderately steep," says Richard Carter, Fidelity vice president of fixed income products and services. "This means the difference between a six-month Treasury bill and a two-year Treasury note is significant. If you are comfortable with the staging of your maturities, have enough cash on hand to meet your needs, and invest in high quality credits, you can allow the investments to mature at par (the face value of a bond), and not concern yourself with day-to-day price and valuation changes."
Making your choice
When deciding how to invest your cash, make liquidity—how quickly you need access to the money—a central consideration. In general, the more comfortable you are with risk and the less liquidity you need, the more yield you can afford to pursue.
Consider the following hypothetical examples:
The bottom line
Even in low-rate environments, there are ways to increase the returns on short-term investments. But as the cliche says in investing, there is no free lunch. More yield generally requires assuming more risk. The key: make sure your choices match up with your goals and your personal tolerance for risk.
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