What income-focused investors should know as they search for higher yield
Yields on most savings and money-market accounts have dropped so low that investors who hunkered down in cash as the financial crisis deepened are now scrounging for better returns. But they still need to tread warily as they reach for higher yield.
Last year, many investors learned the hard way that they can't necessarily bank on what mutual-fund managers call cash -- unless it really is cold, hard currency, preferably insured by the FDIC.
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They saw one of the oldest money-market mutual funds "break the buck," meaning its net asset value fell below $1, after the Reserve Primary Fund's holdings of presumably high-quality but suddenly worthless Lehman Bros. securities triggered a wave of institutional redemptions.
Remaining investors who held shares in the Reserve Primary Fund found every dollar they invested was worth a few pennies less. As of mid-April, some were still waiting for their money.
Owners of auction-rate securities, which some brokerages treated as cash, also saw those securities plunge in value after the market for them collapsed.
Brokerages that sold clients these instruments -- including Bank of America Corp., Merrill Lynch Co., Goldman Sachs and Citigroup -- eventually bought back these securities to make investors whole. Several entered multi-billion-dollar settlements with regulators, who accused them of misleading investors. Last week California sued Wells Fargo Co. on similar grounds.
No Free Lunch
After these events, the U.S. instituted some extra safeguards around the segment of investments that savers treat as nearly the next best thing as a mattress. The Treasury Dept. has extended a guarantee of money market mutual fund assets until mid-September.
Still, it's up to individual investors to uncover any hidden pitfalls in investments designed to act very much like cash.
The bottom line, say money managers, is that for every bit of yield, the investor is probably giving up a degree of safety and liquidity.
"There's no free lunch," said Scott Donaldson, senior investment analyst with Vanguard's investment strategy group. "In order to get higher yields, there is higher risk."
It may be a risk that's worth taking if your time horizon is right. Annual yields on the safest money-market funds -- which generally carry higher yields than the FDIC insured "money-market accounts" offered by banks -- have slid to 0.6%, according to iMoneyNet.
Yields are close to zero if you take your money out in a month's time. The compound 30-day yield on retail money-market funds that invest in Treasurys has slid to 0.04%.
The yield picture isn't much prettier if you lock up your savings in a bank certificate of deposit.
A three-month CD has an average yield of about 0.75%, says Bankrate.com. A six-month CD carries a rate of about 1%.
These ultra-low payouts stem from the Federal Reserve's policy of lowering interest rates to near zero and strong investor demand for government-backed investments.
In fact, investors have moved so much of their money out of the stock market that money market funds and certificates of deposit amount to about 60% of the market capitalization of the Wilshire 5000, estimates money manager W.P. Stewart.
To generate more income, investors have to be willing to let their money sit for longer periods, which means there's more of a chance that something could go wrong. But as you hunt for yield, here are some ways to stay out of trouble:
1. You don't get something for nothing. That's true even when deciding among different varieties of the same investment, such as a money-market fund.
Much higher-than-average yields are actually a red flag, said Paul Reisz, a product manager at bond-fund giant Pimco.
"The yield does actually tell you a story," Reisz said. "What it usually means is that there's some sort of risk taken on and it's usually from the type of instrument being purchased and weighted average maturity of the portfolio."
And keep a close eye on how much of a money-market fund is in floating-rate paper, Reisz added. A high concentration exposes a money fund to interest-rate risk, jeopardizing the manager's ability to keep net asset values at $1.
2. Look for deep pockets. After the Reserve Fund debacle prompted many investors to pull savings from money market funds, threatening to push the net asset value of other funds below $1, Bank of New York Mellon and other big managers bailed out their own money funds.
"You want to go with companies that have been around a long time," said Tom Orecchio, a principal at Modera Wealth Management in Old Tappan, NJ.
Also, pay attention to expense ratios, he said. Expenses for money-market mutual funds can range from 0.2% to 0.7% or more. High fees can depress yields to "next to nothing," he points out.
3. Know your time horizon and risk tolerance. Figure out when you'll want to turn your cash-like investment into real cash that can pay for groceries and mortgage payments.
Many advisers suggest placing three- to six months' worth of living expenses in a bank savings account or other highly liquid account, such as a money-market fund. Despite what happened with the Reserve Fund, only a few of these vehicles have ever not returned investors' principal on demand.
The same can't be said for bond funds. Their net asset value can slide, just like any other mutual fund. But a bond fund's yield might make up for some of that loss.
4. Look at underlying credit quality. Within both money-market funds and short-term bond funds, investors can choose from those that primarily invest in Treasurys; those that invest mostly in debt issued by government-sponsored Fannie Mae, Freddie Mac and Ginnie Mae; and corporate bonds (in money-market parlance, these are called "prime" funds.)
Funds that invest in Treasurys, or direct IOUs from the U.S. government, are considered safest and so carry the lowest yields. Debt issued by the government-sponsored agencies has the implicit backing of the U.S. government.
And corporate debt -- no surprise -- is considered riskiest but carries the greatest potential reward.
Orecchio, of Modera Wealth Management, said he also looks at tax-exempt "prefunded" municipal bonds. It's safer than a typical municipal offering, he said, because the issuer buys U.S. Treasurys as a type of collateral for its obligation.
5. Remember that cash can be trashed. Every yield-producing investment carries some risk, no matter how much a fund manager vows it's just like cash.
Said Reisz: "The perfect representation of cash is the dollar in your wallet."
Laura Mandaro is a reporter for MarketWatch in San Francisco.