About Cash and Cash Equivalents

Recently I posted on the potentially misleading use of annual % return for a small time period, and the differences between mutual funds and ETF's. This post is focused on cash and cash equivalents.

Tools for Managing Cash:

The cash management tools discussed in this post have the following general characteristics:

1) minimal / low risk of default or loss of principal (i.e. you won't lose what you put in)
2) ability to get the money back in relatively short order (i.e. some that day, some over a matter of months, especially if you are willing to pay a penalty)
3) close sensitivity to short term interest rates set by the Federal government (the "Fed Fund" rates) - these rates (more or less) determine what interest rate you will receive
4) these tools are generally not very tax-efficient (with some exceptions) - the interest that you receive is generally taxed as "ordinary income" which is usually your highest effective tax rate

Banks - Checking and Savings Accounts:

Your local bank offers a checking and a savings account. These accounts are protected against loss up to $100,000 (or $200,000 on joint accounts) by the FDIC (Federal Deposit Insurance Corporation). This sort of insurance was instituted after the great depression when many banks failed and left the depositors destitute.

Even though technically the bank is only insured up to $100,000, if you have cash on deposit at a major bank such as JP Morgan, Washington Mutual or Citibank, your "real" chance of loss is effectively zero. These banks are generally "too big to fail" in that if one of them went down it is assumed that the Federal Government would step in and bail them out because of the systemic risk it would cause throughout our entire financial system. Any of these "major" banks also has an actively traded stock on a major market; you'd see the stock fall and have a chance to withdraw your money in virtually any foreseeable circumstance.

Pretty much anyone can set up a bank, however, including some "Internet only" banks. Sometimes these banks do go bust so you might want to limit your cash balances to $100,000 on these smaller institutions. I wouldn't reject them out of hand, however, because often they offer higher interest rates than the "major" banks (they need to do this in order to attract deposits).

Traditionally, checking accounts offered very small interest rates (or no interest at all) and savings accounts offered crappy rates compared to some of the other alternatives we'll get to later in the post. You'd generally be considered a "sucker" or a "rube" if you left your cash in a bank.

The assumption that leaving money in a bank is for the unsophisticated doesn't hold as much water as it did in the past, however. For example, recently Chase (the company that swallowed Bank One here in Chicago) was offering 2.25% interest on checking accounts if you kept a consolidated balance > $50,000, and 4.25% on savings accounts if you were at $100,000. Their rates go up to 4.5% at $500,000 - as noted above you do have an FDIC "default" risk for amounts > $100,000 but this risk is extremely remote if you are talking about a "major", publicly traded bank. These rates change all the time so if you research them you are going to see different rates, but generally in the same ballpark.

As a general rule, you aren't doing too badly nowadays if you have a major bank, link your checking and savings accounts together so that you don't leave much in checking (i.e. a few thousand dollars, maximum) and leave the rest in savings and transfer them back and forth online (instantly) so that the vast majority of your average $ is in your savings account. Checking and savings at a major bank is very liquid; you can get money from any ATM and walk into branches everywhere.

Another item to consider is ease of use. You will likely be interacting a lot with your main checking and savings accounts; you want a solid Internet interface and the ability to talk with a human and / or visit a branch if needed. You can certainly select a smaller operator and have a good experience, but you wouldn't want to continually interact with a bank that provided lousy service whether it was big or small.

To reiterate, one of the key advantages of checking and savings accounts is that there are no penalties to withdrawing the money, and it is available immediately. You may receive less favorable rates and pay more in fees as your balances get smaller, but this varies by bank and can usually be minimized.

Interest Rates:

Interest rates on short term deposits generally track the short-term "Federal Funds Rate". This link shows the Federal Funds rate over the last few years. The rate was 8% in 1990 (not coincidentally this was a recession and a tough time to enter the labor force, as people my age found out) and it went all the way down to 1% in 2003 (for various reasons, this is pretty much as low as it can go). The Fed has embarked on a policy of "tightening" and raising interest rates to 5.25% as of mid-June 2006, from where it has remained unchanged.

This Federal funds rate de-facto sets what banks and money market funds (and CD's) pay out to depositors in interest. If you held cash in 2003 and the Federal rate was 1%, you can bet that at that time the banks were paying so little interest that it was negligible and at that point you were a bit of a "rube" to leave your money in cash at that rate. However, with the rate at 5.25% (your bank will pay less than this, generally) cash is significantly more attractive when compared to other investments.

Note that we are talking about short-term interest rates, or what you'd make on cash equivalents. The long-term interest rates (from a couple of years out to twenty years out) are partially set by the Federal Funds rate and also set by the market and they can vary significantly from one another (here is a good link showing short and long term rates over the last few years). When short term rates were 1% in 2003 the 10 year US government bond was at about 4%; at the end of 2006 short term rates were around 5% and the 10 year bond was about 5%. Short term rates can be higher than long term rates; this is called an "inverted" yield curve and many people think that this is a harbinger of a recession. I won't go into interest rates in more detail here because it is fodder for a thousand posts...

At today's high short term interest rates, "cash" is a very attractive investment. Cash can give you a 5% return with essentially zero risk, and you can get to your money very quickly (try getting money out of your house quickly without borrowing against it - you can't). Thus the popular opinion that you need to "reinvest" your cash into the market quickly or you are missing out on return may have held true in 2003 when interest rates were 1% holds much less true when interest rates are 5%.

Money Market Funds:

Money market mutual funds are traditionally the destination for most excess cash. Unlike savings & checking accounts and CD's, money market accounts are NOT insured against loss. However, money markets have essentially never had a default and the amount of money invested in money markets is gargantuan (in the trillions).

Money market accounts are funds that are typically offered by brokerage accounts such as Vanguard or eTrade as a place to "park" cash that is not invested in the market. In the past brokerage firms made a lot of their profit on the fact that they paid out very low interest rates on cash in customer accounts, but over time rates on money market accounts have gotten very competitive.

Vanguard, for instance, has four different "taxable" money market funds and six different "tax exempt" money market funds. The taxable money market funds currently pay around 5% and the tax exempt money market funds pay around 3.5%. For practical purposes the money market rate of return will follow the Federal funds rate, and the difference between the taxable and tax free money market rate of return is that the tax-exempt issues pay about 1/4 less interest than the taxable accounts; your "after tax" return is thus about the same between the two investments if you are in a high marginal rate (i.e. make more than say $100k or are facing the AMT).

These money market funds are extremely liquid; you can write checks from your money market fund and get at your money very quickly without penalty (as long as you keep the total balance above some designated minimum).

In general, you won't be doing badly if you park your cash into a money market mutual fund. You will probably receive a bit higher return than you would at your bank savings account (if you have a big balance at the bank of say > $25,000; for small balances you'd probably be far better off in a money market mutual fund because the rates are constant once you reach the minimum, say $3000 for Vanguard; banks generally use "graduated" rates and tie it to other services).

One "risk" as traditionally defined by investment advisers is that the money market interest rate generally moves with the Federal funds rate. For example, right now you are probably getting around 5% on a taxable money market fund, but if the Fed lowers interest rates by a percentage point, your money market will soon start paying you 4%. The risk is an "opportunity cost" in that you COULD have "locked in" that 5% rate in a CD (see below) or a bond (not covered here, separate topic), but you didn't, and now as the rates go down that 1% "lost" interest point is hurting you. Most lay-people wouldn't view this as too much of a risk because they didn't technically lose any money, but the financial advisers are correct, as well.

Certificates of Deposit (CD's):

Certificates of Deposit (CD's) are offered by banks and subject to FDIC protection against loss (up to the total maximum of $100,000 or $200,000 for a joint account). CD's generally have a "term" such as six months or one year and offer a fixed interest rate that doesn't change throughout the time period. Generally the rate on CD's increases as the time horizon gets longer, but times are strange with the inverted yield curve as noted above and sometimes long horizons have lower interest rates than short horizons.

CD's are unlike money markets in that there is a substantial penalty for early withdrawal. For example, on a five year CD, early withdrawal may result in a loss of six months interest. As such, CD's are not immediately liquid assets, although in a pinch you can get your money and worst case you lose some interest and get your principal back (original investment) unless your time horizon was really short.

CD's are also usually "tiered" in that the more money you put into the CD, the higher the interest rate the bank will offer you. For example a "jumbo" CD is typically around the $100,000 threshold, which is the FDIC limit for a single account for insurance coverage, and the bank will offer you a higher rate on that money. Money markets, on the other hand, usually pay the same rate to everyone once you cross a small minimum (maybe $3000 - $5000).

If the interest rates go DOWN and you invested in a CD, you "win", because you still get the higher rate. If interest rates go UP and you invested in a money market, you "win" because the money market generally adjusts and receives the higher rate.

Treasury Bills:

I was going to cover iBonds in this article, but, upon reflection, they can't be redeemed within a year so they can't really be considered cash or cash equivalents. CD's also have a time minimum but you CAN redeem them early if you want to pay a penalty that isn't too onerous, so I would still consider them to be closer to cash equivalents.

Treasury bills, on the other hand, are sold in 4 week, 13 week and 26 week increments. The bills are issued by the Federal government so there is effectively zero default risk (if the US government defaults, the whole financial system is doomed, so that would be the least of your worries). The bills are bought at a discount from par, meaning that you might pay $960 for a bill that will be worth $1000 at maturity (if it is only a few weeks at an interest rate of, say, 5%). The interest rate doesn't fluctuate during the term of the bill.

The Treasury Bills can be bought online at http://www.treasurydirect.gov/ without any fees for setting up an account or making a purchase, or holding securities to maturity (there is a charge if you redeem early). The US Government will sell your security for the highest price available if you want to sell prior to maturity and charge you $45. Since the market is so large and liquid and these securities are essentially commodities, they function just like cash because you can easily get your money out quickly if you need to do so (less $45 and the portion of interest remaining).

Tax Considerations:

Tax considerations vary by type of investment. Taxes are complicated and this should be treated as a general summary...

For money market funds, you receive interest in the form of dividends each month. This amount will be considered ordinary income if you are investing in a taxable money market fund. As a general rule ordinary income is your least-favored tax treatment, resulting in a rate of about 35% for high income earners (on the margin). If you hold a money market account for five months, you will thus report five months of income on your tax return.

For non-taxable money market funds, you will receive your distribution monthly, and you need to report it, but you won't pay taxes on it for Federal purposes. Generally tax-free money markets pay about 35% less than taxable money markets, so it more or less washes out in the end. If your non-taxable money markets invest in "private activity" bonds you may have to pay taxes on this portion of your income for AMT (alternative minimum tax purposes).

Banks pay interest on checking and savings accounts monthly, like money market funds. Thus you will be taxed in the current year at ordinary income rates.

For Certificates of Deposit, you won't be taxed until your CD matures. Thus if you buy a one-year CD on July 1 by 12/31 of that year you "earned" 6 months of interest; but since you haven't received that interest yet in cash (and aren't entitled to it unless you want to pay a substantial penalty) you don't have to report it as income during that year. You will have to report income on it the following year, however, when it comes due.

For Treasury Bills, you won't be taxed until you redeem the bill. Since many of the durations are short, however (4, 13 or 26 weeks) the amount of interest that you are "deferring" into the next year to keep from the taxman (for a little while) is small.

Recommendations:

As always, do your own research. This blog just represents my opinions.

In today's "inverted yield curve" environment, holding cash at around 5% for ZERO risk isn't a bad deal and is something to consider. At the very least, don't feel rushed if you have some cash in your money market account; it isn't "dead money" the same way it was in 2003 when short term interest rates were around 1%.

It isn't terrible to hold some cash in the bank, if your savings account is paying decent interest (within 1% or so of what you'd get in a taxable money market fund). Else you should probably hold the minimum in the bank and "sweep" the rest into a taxable money market account, unless you are a high earner in which case you may want to consider a non-taxable money market account. With the Internet it is pretty much as snap to move between your money market account and your bank account via online transfer; if the situation was dire you can also write a check against your money market account (this should be an exception, not the rule).

You might want to "lock in" today's rates with a 1 year CD; you get a bit of a tax deferral (it shows up on next years' tax return) and if things were dire you could always pull out your money (and just take a hit on your interest earned). Given that today's rates are pretty high and the yield curve is inverted (or flat), I don't think I'd recommend putting a lot of effort into putting the money into CD's, but this could change if short term rates fell and long term rates went up. If you go to a little local bank to get a CD you'll probably get a higher rate, but you might not want to go too far beyond the $100,000 FDIC guarantee ($200,000 for joint accounts). It is easier to buy CD's in the same bank where your checking and savings accounts are located, because then you can control all of your funds from one console, but since you aren't going to touch your CD early unless the situation is dire you aren't buying that much with consolidation. Right now Chase is offering 5% for one year CD's that are more than $10,000 - this is a pretty good rate and you 'lock in' this rate, as opposed to money markets where the interest rate could go down (or up) and get the tax deferral into next year. For consideration, Vanguard's Prime Money Market Fund (VMMXX) has a yield of 5.1%, but you are taxed on what you earn each month and this rate will fluctuate during the course of the year.