Investing Wisely

Energize short-term investments

Don't let today's economic and political uncertainties scare you into leaving cash sitting idle in a bank account. Put it to work, with little risk.

By Diane Weber
Senior Editor

These days, perhaps the only investors sleeping soundly are those who've pulled their money out of the markets and tucked it under their Sealy Posturepedics. Still, if you let fear of a recession or the bear market paralyze you into doing the same—or, almost as bad, leaving too much cash in your checking or savings account—you'll lose out to two more-subtle predators: inflation and taxes. That's why financial advisers generally recommend keeping only money you need for current bills in such accounts.

With the rest of your cash savings, you can do better—often with little or no appreciable increase in risk. And with potential returns from the mercurial stock and bond markets uncertain at best, steady returns on your cash, however modest, offer at least a bit of comfort.

As always, the potential increase in return hinges on your willingness to chance some loss of principal in exchange. If you'd rather wrestle crocodiles in the Australian outback than risk losing a dime, your choice is relatively narrow: Stick with money-market accounts or mutual funds, certificates of deposit, or Treasury bills.

Bank money-market accounts generally pay the least, but they offer the protection of FDIC insurance. Money-market mutual funds usually pay more, but they aren't FDIC-insured. Those of prominent fund companies are still considered super safe, however. CDs are insured, though banks that issue them exact penalties for withdrawal before maturity. Treasuries offer the ironclad safety of Uncle Sam's backing, as well as tax advantages.

Which is best for your needs will depend in part on where interest rates stand when you invest. "Particularly in this environment when we're in and out of inverted yield curves [meaning short-term interest rates are sometimes higher than longer-term ones], you'll have to do a little comparative shopping to squeeze the most yield out of your dollars," says Stewart H. Welch III, a financial planner in Birmingham, AL.

You'll also have to factor in how much liquidity you really need. Money-market funds are best for cash that you'll have to spend soon or that you want to keep immediately available for short-term emergencies and opportunities. The top yielders recently paid as much as 3 percent annually—typically by opting for securities with slightly longer maturities than lower-paying funds or by absorbing the management costs they'd normally charge shareholders. To search for top money-market payers, visit www.ibcdata.com/mfs/toppers.htm.

For cash you can afford to lock up for a while, consider CDs or Treasuries, particularly if interest rates continue to drop or remain relatively flat. You can search for top-paying CDs from FDIC-insured banks at www.bankrate.com or www.moneyrates.com. The best of the three-month and six-month offerings were recently paying around 4.0 percent. Three-month and six-month Treasury bills both were delivering about 2.2 percent.

Other ways to boost returns

With rainy-day savings that needn't total a specific amount or cash you won't need for several years, you can afford to gamble a little more to get higher yields. Here are some vehicles that could improve your return without undue risk to your principal. All the mutual funds are no-loads and have five-star ratings from Morningstar, the fund-tracking firm:

Strong Advantage Fund—Investor Class (800-368-1030). Use this ultra-short corporate bond fund for cash you won't need for two years or so, says Stewart Welch. It invests mainly in mortgage-backed and high-quality corporate bonds of short maturity—recently about eight months, on average. Strong Advantage spices its portfolio with some lesser-quality bonds, but its managers know how to minimize overall risk, Welch adds. That's demonstrated by the fund's long-term track record: It hasn't had a negative return in any year within the past decade, even in 1994 and 1999, when interest rate spikes created tough market conditions for bonds. Over the 12 months through Oct. 8, the fund's total return was about 5.6 percent; over three years, the return averaged 5.8 percent annually.

"Even in an ultra-short-term bond fund like Strong Advantage, you can face price fluctuation when interest rates rise," Welch warns. But a one-percentage-point increase in rates would likely shrink the fund's net asset value—and thus the value of your stake in it—by 0.7 percent, according to statistics from Morningstar.

Eclipse Ultra Short-Term Income Fund (866-232-5477). Another two-year-plus vehicle, this ultra-short corporate bond fund invests in US government and agency bonds and those of domestic corporations considered socially responsible. Should interest rates rise a percentage point, it still wouldn't cost you a tremendous amount of principal; the fund's net asset value would likely drop by 0.9 percent.

In exchange for the greater risk, the fund returned 5.9 and 6.1 percent for three and five years, respectively, on average. A caveat: Those figures reflect the fund's unusually low expense ratio—recently just 0.12 percent—partly the result of management's decision to waive certain fees and management expenses, which it could opt to reinstate at any time. So before investing, you might want to ask how long those fee waivers are expected to continue.

Options for the slightly more daring

If you're willing to accept a bit more principal risk for the possibility of higher returns, consider these three five-star no-load alternatives, all of which have strong long-term track records:

Montgomery Short Duration Government Bond Fund (800-572-3863). Variety enlivens the performance of this fund, which is most appropriate if you have at least three years to invest. Although the fund invests at least 65 percent of its assets in government bonds (and recently that portion topped 94 percent), it's sometimes more willing than its peers to venture beyond government bonds and into inflation-protected issues, corporates, munis, and other riskier fare. The fund's managers sometimes trade actively in search of better values, but overall they keep expenses relatively low. And though this fund is more interest rate sensitive than the previous selections—you could lose about 2 percent for a one-percentage-point rise in interest rates—it's less sensitive than many of its peers, and it hasn't had a negative return since its inception in 1992.

Over the 12 months through Oct. 8, the fund returned 10.6 percent. Over three years, it returned an average of 6.3 percent annually.

Vanguard Short-Term US Treasury Fund (800-662-7447). Consider this short-term government bond fund if you have three to five years to invest, says Del Mar, CA, financial planner John T. Blankinship Jr. At least 65 percent of its assets must be Treasuries, according to its charter, and recently 90 percent were in either government or agency bonds. A low expense ratio—just 0.27 percent—helps boost the fund's returns. Over 12 months, its return was an impressive 11.3 percent. Over three years, its annual return averaged 6.3 percent. Morningstar estimates that a one-percentage-point rise in interest rates could shrink this fund's net asset value by 2.3 percent.

Vangurd Limited-Term Tax-Exempt Fund (800-662-7447). If you're investing for three to five years and favor municipal bonds, check out this fund, which boasts the lowest expense ratio among its short-term muni peers. Minimizing costs helps its managers deliver above-average returns with below-average risk. More than half the fund's assets recently were in issues rated AAA, yet over 12 months it returned 8.3 percent. (The latter is equivalent to 13.5 percent if you're in the new 38.6 percent top federal tax bracket.) Over three years, the fund returned an annualized 4.8 percent (a 7.8 percent taxable equivalent), on average.

This fund is the most rate-sensitive of those recommended here: Its net asset value could drop about 2.9 percent for each percentage-point jump in rates. Though a near-term rate spike seems unlikely, that's something to keep in mind.

A snapshot of short-term cash investments

Diane Weber. Energize short-term investments.

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