*NOTE: Updated version of this post available "Early 2021 edition" available here.
It can be helpful to think of investing as a ladder of options. At the very bottom of the ladder, the most conservative options are what we call cash-like instruments. This includes including actual dollar bills, high yield savings accounts, no penalty CDs, money market funds, other liquid accounts, cash-like funds, and short term federal bonds. At the time of this writing, these all return 2.75% or less before tax and inflation.
It's not how I keep my spare cash, nor what'd I'd recommend. That's the Ultimate Liquidity Portfolio, explained in the book I co-wrote with Shannon Matthiesen here.
What these investments have in common
1) strong nominal protections on your money
2) reasonably consistent, very low, and in some cases guaranteed interest rates/rates of return
3) The ability to get your money on short notice (possibly within minutes, although for the sake of this we are considering anything that can have its investment returned within 30 days)
7 Ways to Stash Your Cash
- Cold hard cash
For some people, it's hard to beat the appeal of cold, hard dollar bills stuffed under a mattress. It's the most liquid emergency fund you can think of. You literally lift up your mattress and grab it when you need it. Depending on how you define an emergency (nuclear meltdown), this might be the best answer for you. The issue is that you lose money to inflation over time.
- High Yield Savings Accounts
Available from online banks like Marcus, Ally Bank, and more. Their yield tends to follow a banks cost of funds minus a small discount. The federal government guarantees your account up to $250,000 ("FDIC insured"). The rates paid on high yield savings are determined by a bank's cost of funds; which is a combination of factors including federal reserve rates, deposit amounts, and more.
More recently, investing websites such as Betterment, Wealthfront, and YieldStreet have offered savings-like accounts that are outsourced to banks, that tend to be competitive. You're adding an extra layer but in some cases getting higher returns.
The interest on high yield savings accounts fluctuates with market conditions.
There are often minimum and maximum deposit requirements, as well as limits on the number of withdrawals that can be made per month.
- No-Penalty CDs
Available from some online banks, no-penalty CDs also offer nominal value protection up to $250,000. Unlike savings accounts, CDs do boast a guaranteed rate, good when rates are declining. Only no-penalty CDs or one-month CDs (currently uncompetitive) are considered as cash-like instruments; other CDs have penalty fees and/or terms longer than 30 days. If interest rates on savings accounts are declining, an equivalent rate CD will do better.
- Money Market Accounts
Available through brokerages like Fidelity, Vanguard, and others. These slightly riskier accounts invest in short term debt instruments, some of which are government backed or government linked, and some of which are viewed as very secure short term debt (for example, debt from large banks or corporations). The rates paid on money market accounts are related to the federal reserve discount rate, plus a small amount to price the risk of non-government debt if that's in their holdings. A special class of money market accounts are those that only hold tax-exempt securities called "Municipal Money Market Funds". These are usually attractive only to a small subset of individuals who are taxed at very high rates.
The rates fluctuate with the market and are not guaranteed.
- Other liquid accounts
Some companies offer products that can look and feel like a high yield savings account. Mercedes Benz offers "First Class Demand Notes" to accredited investors only, with a current interest rate of 2.75%. General Motors offers Demand Notes to all investors with a rate of 2.50%.
The rates change with market conditions but tend to be 0.25% - 0.50% higher than competitive high yield savings accounts.
These are similar to bank accounts in that you have ready access to the funds. The difference is, unlike banks, you do not have a federal guarantee up to $250,000. This could matter if General Motors or Mercedes went bankrupt.
Is it secure? The companies have been around for decades, their credit ratings indicate that they have a less than 0.2% chance of going broke in a given year, even if they go broke it's not clear you would lose money, and they currently show no signs of significant financial distress.
In other words, the risk seems "priced correctly". However - will you still sleep soundly at night for that extra bit of return? GM is more likely to go bankrupt than the US government. You are getting paid (a bit) for this risk - decide whether it's worth it.
- Cash-like funds
Some exchange traded funds invest in short term debt. Examples include MINT by PIMCO, JPST by JP Morgan, and GSY by Invesco. When rates are going up these funds tend to be the first to benefit.
There is not a nominal guarantee on your money. However, none of the funds listed above has lost any significant principal as long as they've been around.
Some people like these funds because they can hold instruments that are outside of the US, somewhat diversifying a US-centric risk. On the other hand, they usually don't hold US treasuries and therefore the income is almost completely taxed at ordinary income rates.
There might be some trading costs at your brokerage which can impact your profit. Also, the funds charge a fee for managing this account for you which can reduce your return.
- Treasury bills
Available through brokerages (usually without a fee), or directly from the US Government (https://www.treasurydirect.gov/RS/UN-AccountCreate.do), treasury bills are loans to the United States of America. For the sake of our analysis, we use 1 month treasuries. The rates paid are dictated by the results of federal reserve auctions.
1-month treasury bills offer nominal protection, a guaranteed rate, and are backed by the full faith and credit of the US government.
Some cash like funds hold short term US treasuries such as SHY. These funds can lose value depending on the macroeconomic environment, although historically they tend to be quite stable.
Main differences to consider
Difference #1: Tax rates.
High Yield Savings accounts, CDs, and other liquid deposit accounts are taxed at the highest tax rates. This is known as your marginal ordinary income rate. These range from 10% - 37% federally, and 0% - 13.3% on a state and local level. To understand how this will impact your returns, find your federal https://taxfoundation.org/2019-tax-brackets/and state rates right now and write them down. https://taxfoundation.org/state-individual-income-tax-rates-brackets-2019/.
Treasury bills (debt issued by the federal government) are not subject to state and local taxes, but are subject to federal taxes.
Money Market and cash-like funds usually lie somewhere in between. Money market funds typically hold a variety of different securities, and you will be exempt from state and local taxes on the portion that applies to you. In other words, if a fund gets 30% of its income from federal government bonds, that 30% is exempt from state and local tax. To find this out, you would search for the latest tax disclosure statement for the fund. The ratio might vary dramatically - Vanguard lists both "Federal Money Market" and "Prime Money Market" as money market funds. The former is 78% federal securities, and latter just 28%. We also talked about a special subset of funds that will hold only tax exempt securities - for example Vanguard has a "California Municipal Money Market Fund" which are not taxed at all at the federal or state level.
How does this play out in practice? Let's take the real world options as of today, assuming 2018 tax exposures. We'll simply list the "quoted" yield, the actual yield for a high income California investor (CI), and the actual yield for an "average" investor (AI) who pays 22% federal tax and 4% state tax.
Difference #2: Liquidity in crisis
All of these are extremely liquid accounts. There are a few slight differences.
Cash is available the moment you need it.
High Yield Savings accounts are typically accessible within a couple of business days.
No penalty CDs are a little slower - since there is a breakage process that needs a bit of documentation.
Money Market and cash like funds theoretically always have liquidity to meet sales. Once sold it might take a couple of days for access. Theoretically in a full blown panic, your funds might not be available for up to a couple of weeks since you are effectively "waiting in line" for your redemption with other people.
Demand notes should act like high yield savings in most circumstances. There are some restrictions, such as minimum withdrawals and deposits, that can make the process a little less convenient. Also, similar to money market funds, in the event that everyone wants their money at the same time, it is not clear how quickly you would get paid.
Treasury Bills purchased directly, are available at expiry. In other words, if you are buying 30 day treasuries every 30 days, you would get access to the capital at the end of every 30 day period. If you bought some every day for thirty days, then the cash would be available as each treasury matures.
Summary - What To Invest In
In the current interest rate environment it doesn't make much difference where you keep your money. So I'd suggest two things. First, if you're not sure, split your money between two options for a couple of months and see which "feels right". Second, don't do anything that's an emotional stretch - it should be in whatever "feels" best to you. For example, if you get extra peace of mind from skipping the additional risk of the money market fund, then feel free to cross that off your list.
It is important however, to monitor the interest rate environment for dramatic changes.
In 2010, money market funds and treasury bills were earning less than 0.2% before taxes, while high yield savings accounts were over 1.4%. Banks still wanted deposits even though the federal government paid next to nothing for loans. If you had "set it and forget it", you would have been giving up 1.2 points of return.
For several months in 2018, treasury bills paid more after tax to most investors than either high yield savings or money market funds.
Today, money market funds pay more after tax than treasury bills.
My personal experience: I've invested money in high yield savings (through Marcus), short term ETFs (MINT), and money market funds (through Fidelity). Marcus frustrated me because I knew I could make more, so ultimately I've put more of my money into the other instruments. The largest investment I have in short term liquid instruments is in the ULP, which we describe in this post. But I still have a split between the three.
If you want to get yields of 3% or more, read this post.
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