While stocks and bonds are heavily covered in the media, the cash-equivalent portion of an investor’s portfolio is often overlooked.
Cash equivalents include money market mutual funds and various types of short-term bond funds.
“Cash should always be a sector in any portfolio. What changes, depending on the market conditions, is how much allocation to make to the cash sector,” says Deborah Cunningham, chief investment officer of global money markets at Federated Investors in Pittsburgh.
Volatile investment markets underscore the importance of owning cash assets. During the first three weeks of 2019, the Vanguard Total World ETF’s (ticker: VT) share price ranged from a low of $64 to a peak of $69 for roughly an 8 percent range. The SPDR S&P 500 ETF ( SPY) spanned a range of about 9 percent over the last month, from its low of $244 to its crest of $266.
Cash equivalents provide income and temper the unpredictable financial investment returns of volatile stocks and bonds.To craft a successful cash-equivalent portfolio, investors must understand interest rate policy and its effect on investments.
After four federal interest rate hikes last year and more predicted for the future, knowing how interest rates impact fixed-income funds factors into cash-asset planning.
As interest rates rise, bond values decline, with long-term bonds falling further than short-term ones.
[Read: Use Cash to Your Advantage as Rates Rise.]
J.R. Robinson, founder of Financial Planning Hawaii and Nest Egg Guru in Honolulu says, “As a financial planner, making clients cash work harder is an easy way to add value. I often meet with investors who have tens or hundreds of thousands of dollars in low- or no-interest bearing accounts. If I can help them earn an additional 1 to 2 percent or more on this cash, this simple exercise alone often more than covers my fee.”
For investors looking to balance their portfolios with cash-equivalent investments, here are a few places to look:
— Money market mutual funds.
— One-month U.S. Treasury bills.
— Short-term municipal bonds.
— Short-term government floating rate debt.
— Short-term corporate bonds.
Money Market Mutual Funds
Money market mutual funds, not to be confused with lower yielding bank money market savings accounts, invest only in highly liquid cash and cash-equivalent securities with high credit ratings — typically government and commercial debt. Money market funds’ interest payments will increase along with escalating rates.
Money market mutual funds include the Vanguard Prime Money Market Fund with a current yield of 1.94 percent, Fidelity Money Market Fund with a current yield of 1.86 percent and Schwab Value Advantage Money Fund with a current yield of 1.78 percent.
“It is important to remember that these funds are not FDIC-insured. And while they target a constant $1 net asset value, there is no guarantee that they don’t ‘break the buck’ and drop below $1 a share,” says Michael Ciccone, certified financial planner and associate vice president at Tradition Advisers in Summit, New Jersey.
One-Month U.S. Treasury Bills
Steven Jon Kaplan, CEO at True Contrarian Investments in New York City, explains a potential problem of cash-equivalent investments. “Cash-equivalent money market funds don’t pay enough interest, and those which are not money market funds will often lose value when interest rates are rising,” he says.
Kaplan favors one-month U.S. Treasury bills, currently yielding 2.36 percent. These ultra-safe, fixed income and highly liquid investments can be purchased directly at TreasuryDirect.gov or through a broker. Since the interest is free of state and local taxes, these investments are particularly suitable for investments in high-tax localities like New York City or San Francisco.
A New York City or San Francisco resident in a relatively high tax bracket of 12 percent combined for state and local income taxes earns an equivalent yield of 2.6 percent, Kaplan says.
[Read: How Investors Can Win as Interest Rates Rise.]
Short-Term Municipal Bonds
Short-term municipal bonds are a fixed-income cash-equivalent investment for high tax-bracket investors. Muni bonds are an attractive alternative when comparing its tax-equivalent yield with corporate bond funds. Alan Trice, head of advisory services at Gurtin Municipal Bond Management in San Diego, touts the short reinvestment cycle of ultra-short, muni-bond funds. The high credit quality and tax benefits make short-term muni bonds or funds even more desirable.
The iShares iBonds Sep 2020 Term Muni Bond ETF ( IBMI) offers investors exposure to investment-grade municipal bonds that mature before September 2020. With a 30-day SEC yield of 1.59 percent, the tax-equivalent yield for an investor in the 24 percent tax bracket would be about 2.2 percent.
Short-Term Government Floating Rate Debt
Floating rate notes, first issued by the U.S. government in 2014, pay a variable interest rate based on 90-day Treasury bills’ returns plus a spread. As interest rates rise, so will the payments of these investments. FRNs issued by the U.S. government are safe and free of default risk.
Ciccone suggests the WisdomTree Floating Rate Treasury ETF ( USFR). The current yield is 1.67 percent. The fund tracks the price and yield performance of the Bloomberg U.S. Treasury Floating Rate Bond Index. With an ultra-low duration of 0.02, as interest rates rise, its value will remain relatively stable.
[Read: Why Corporate Bonds Are Risky With Higher Interest Rates.]
Short-Term Corporate Bonds
Like its municipal counterparts, short-term corporate debt ETFs track the shorter maturity corporate bond market, typically less than five years. The types of bonds owned within this category range from investment-grade to lower-quality junk bonds. Fund prices will be somewhat more volatile than those of money market mutual funds, one-month U.S. Treasurys and short-term government floating rate debt due to the longer average durations.
Among the most highly-ranked U.S. News short-term bond funds is the iShares 0-5 Year Investment Grade Corporate Bond ETF ( SLQD). The fund tracks the investment results of the Markit iBoxx USD Liquid Investment Grade 0-5 Index composed of U.S. dollar-denominated, investment-grade corporate bonds with maturities less than five years. With a 2.56 percent yield and an enviable 0.07 percent expense ratio, there’s a lot to like here.
To recap, investors must remember the benefits of a well-rounded portfolio. For long-term success, consider cash as the smart counterbalance to riskier stock and bond investments.
More from U.S. News
10 Investing Tips for Busy People
10 Skills the Best Investors Have
7 Cheap Dividend Stocks Under $10
5 Best Cash Equivalents Amid Rate Hikes originally appeared on usnews.com
