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Tuesday, February 16, 2010

Extract More Yield from Your Savings

Investing tip of the month from Morningstar Investment Research Center by Rachel Haig.

If you're looking for somewhere to stash your cash for a relatively short period, you are probably familiar with the traditional vehicles: savings accounts, money market accounts, money market funds, and certificates of deposit. These vehicles have all been around for some time and have made their way into the general personal finance lexicon.

These are fairly straightforward and stable investments, so it makes sense that there is little in the way of new reflections on these different vehicles. However, like most investments, your short-term savings options look a bit different now than they did before the economy began its nosedive in the fall of 2008.

For one, it's much harder to find an attractive interest rate. Now, investors are lucky to eke out gains of over 1% from these investments--hard to swallow not simply because many investors were accustomed to returns over 3%, but also because these minuscule returns may find it increasingly difficult to keep pace with future inflation.

Second, one of the most-favored options in recent years now looks much riskier: the money market fund. Morningstar's Director of Fixed Income Research, Eric Jacobson, says the future of money market funds is uncertain after 2008 when an established fund famously "broke the buck" (its NAV fell below $1 per share).

Savings Account

This is your typical bank account.

Positives: The Federal Deposit Insurance Corporation (FDIC) insures bank deposits. Through Dec. 31, 2013, the FDIC temporarily guarantees higher amounts, up to $250,000 per depositor. After that date, the FDIC will insure its standard amount of $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor. Savings accounts also have flexible withdrawal and check-writing privileges.

Negatives: This account is probably only paying you pennies.

Money Market Account

This is a savings account that pays money market rates. The yield will fluctuate depending on the direction of interest rates.

Positives: Money Market accounts offer higher rates than regular savings accounts, and they are still FDIC-insured.

Negatives: Rates are now only a fraction of what they once were. While you are still likely to do better here than in a traditional savings account, you shouldn't expect much in the way of extra cash. Initial deposits for these accounts are often high, starting at $5,000 or $10,000, especially for the accounts with higher interest rates. However, in recent years many institutions have lowered their initial deposit requirements, some to as low as $500, and a few do not have a minimum requirement at all. Money market accounts also restrict the number of checks you can write and withdrawals and transfers you can complete each month, making these accounts less liquid than regular savings accounts.

Money Market Fund

A money market fund is a mutual fund that invests primarily in low-risk, short-term investments such as Treasury bills, government securities, certificates of deposit, and other highly liquid, safe securities. Money market funds try to maintain a net asset value of $1 per share. Like money market accounts, money market funds' yields will fluctuate depending on the direction of interest rates.

Positives: Money market funds tend to offer higher rates of return than savings accounts and money market accounts and are typically considered very safe.

Negatives: Unlike money market accounts and savings accounts, money market funds are not FDIC-insured. Rates for money market funds, like those for money market accounts, have significantly shrunk recently. Additionally, money market funds are increasingly under scrutiny for presenting more risk than investors acknowledge since the Reserve Primary Money Market fund, one of the U.S.' oldest and largest money market funds, "broke the buck" in September 2008. Morningstar's Director of Personal Finance, Christine Benz, says such turmoil is unlikely to become widespread in money market funds, but investors should be aware that it is possible to lose money. Benz advises investors, "Your best bet is to stick with low-cost money market funds that don't need to stretch for yield from large, reputable shops that have the resources to fulfill their promise."

Certificates of Deposit

Commonly referred to as CDs, these represent a fixed-income debt security, usually issued by chartered banks. The minimum deposit is usually $1,000, and the maturity terms can vary from short-term to several years. Usually longer terms correspond with higher interest rates.

Positives: CDs frequently have higher interest rates than money market accounts and savings accounts, and they are FDIC insured. Furthermore, the rate is fixed, so you know the return you will receive ahead of time.

Negatives: The drawback is that CDs are by far the least liquid option. Once you deposit your money, it is locked in for the duration, and you will pay penalties if you withdraw it early. If you can imagine needing your money before the term of the CD, this is not the option for you. Benz also warns of another risk: "If you go the CD route, be mindful of the fact that many carry 'automatic renewal' features, meaning that your money will get rolled over into a new CD once the first CD matures. If your CD has such a feature and you're not paying attention, you could lock up money that you might need to get your hands on."

We don't blame you if you think none of these looks particularly appealing. Beyond giving up and accepting lackluster returns, your option is to consider upping your risk level to get some higher yields.

Alternatives If You're Thinking about Moving up the Risk Ladder

Short-Term Treasury and Government Funds

Treasury funds are the next step up from money market funds. These funds have very little risk, and accordingly, yields are still pretty low. This category was one of the few bright spots last year, but it has a year-to-date gain of only 3.0%.

Our Analyst Pick in the category is Vanguard Short-Term Federal (VSGBX). Its 0.21% expense ratio is low enough that management's close-to-the-vest strategy of leaning on government mortgage-backed securities and agency debt has produced topnotch long-term returns, with less risk than the competition.

Short-Term Bond and Muni Funds

If you want to go up another notch, look to short-term bond and municipal funds. Short-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and have durations from 1 to 3.5 years. Muni national short portfolios invest in bonds issued by various state and local governments. The income from these bonds is generally free from federal taxes. These portfolios have durations of less than 4.5 years. Short-term bond and municipal funds offer similar risk/reward profiles (munis could be slightly riskier)--the main difference is the tax treatment.

These funds are fairly safe in the grand scheme of investment vehicles, but it is possible to lose money here. Over half the short-term bond category and 25% of the short-term national muni category lost money last year. The funds that stuck to plain-vanilla styles generally made out well. Most of these funds are now back in the black for the year to date.

We would advise staying away from ultrashort bond funds. Some blew up badly last year, and while we think most managers have learned their lesson, these funds have shown themselves to be overly risky. Long-term bond funds are also a less appealing option because their long durations make them more interest-rate sensitive than their short-term counterparts.

Short-Term Bond Fund Picks:

T. Rowe Price Short Term Bond PRWBX

After many short-term offerings were thrown way off kilter in 2008, this fund's dependability has become hard to ignore. The secret to the fund's success is simple: Manager Ted Wiese avoids the market's more-esoteric bonds and derivatives, keeps the fund well-diversified across individual sectors and issuers, and makes sure that the fund is compensated for the risks that it takes. Although the fund may take on more corporate credit risk than some rivals at times, Wiese's (and the firm's) shareholder-oriented mindset makes the chance of a nasty surprise infinitesimal. This fund is easy to own and easy to recommend.

Vanguard Short-Term Bond Index VBISX

This fund is designed to track the Barclays Capital 1-5 Year Government/Corporate Index, sticking to a mix of mostly government bonds and some investment-grade corporates. It doesn't carry much credit risk, boasts a solid long-term record, and charges an ultralow price tag. But here's a note of caution for the near term: While the fund's large Treasury stake gave it a boost in 2008's panic-stricken climate, that won't work in the fund's favor if Treasury rates start to climb off current lows. Over the long haul, though, this fund is solid.

Short-Term National muni Fund Picks:

Fidelity Short-Intermediate Municipal Income FSTFX

This fund benefits from Fidelity's deep municipal research capabilities and a relatively low price tag. We also like that the fund doesn't take on a lot of risk, as shareholders here expect a smooth ride. And manager Mark Sommer, who has been at the helm for more than five years, delivers just that.

T. Rowe Price Tax-Free Short-Intermediate PRFSX

This fund is a solid all-around offering and has delivered steady results over the long term. Management takes few risks here, sticking mainly to high-quality bonds and avoiding large interest-rate bets. The fund's restrained approach, combined with its below-average expense ratio and solid returns, makes this a solid pick for conservative muni investors.

As always, there is a trade-off: if you seek higher returns, you will have to take on more risk. Benz emphasizes, "If an investment is offering a substantially higher yield than a money market account, fund, or CD, you can be sure it's taking on a good deal more risk, too."

Which Option Is Right for You?

The key is determining how much risk you can take on, and how important it is for you to be able to access your savings quickly. For emergency funds and other money that you will want immediate access to and do not want to risk losing, money market accounts and funds remain your top options. If you want to slightly up your yield and can handle not being able to access your money for a set period, consider a CD. For higher yields (and if your time horizon is a year or more), think about short-term government, bond, and muni funds. Finally, for all of these investments, it is important to consider fees when you are comparing yields to make sure you are really getting the best deal.

Morningstar Investment Research Center is great tool for new and veteran investors. It's chock full of unbiased analyst reports, tools for evaluating your portfolio, and lessons on how to invest. The best part is that it's free to all valid library cardholders! Begin now or learn more.

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