Everyone needs to build an emergency fund in order to avoid having to go into credit card debt as a result of a large expense, job transition, or disability. With interest rates on checking accounts essentially at 0%, I want to suggest some alternatives for your extra cash.

The most common options are a money market account, money market fund, or certificate of deposit. Money market accounts and certificates of deposit yield about 1.0-1.2% right now if you look hard (as in, go to bankrate.com and compare it to your local banks and credit unions) and are willing to deposit a decent amount of money, whereas money market funds yield closer to 0.5%. Money market accounts are FDIC or NUCA insured up to a large limit per bank, as opposed to their money market fund cousins, which are tied to an investment and have a small risk of losing value in extreme situations. With certificates of deposit, which are also FDIC or NUCA insured, the money is tied up until it expires unless you pay a penalty. One option with certificates of deposit is to build a ladder of CDs expiring every one or two months, so that if you need access to the money, a portion of it becomes available more often as the CDs expire.

Similar to a CD ladder is to build an individual bond ladder. You would not want to put all of your emergency fund in individual bonds because they are less liquid (you have to sell the bond, wait for it to clear and then wait for a check from your brokerage) but you could put a portion of it in bonds expiring on different dates 6-12 months out, and then roll them over as they expire. This option is not worthwhile right now because highly profitable companies, and the federal government, have yields to maturity from 0.1% to 1.0%, so there is nothing to gain in exchange for taking on the risk of less liquid, individual securities that can lose value if you sell them prior to maturity. It also takes time to research bonds, their credit ratings, yield to maturity and expiration dates. Note that individual bonds held to maturity will return the original loan amount unless there is a default, so even if they lose value in the meantime because interest rates rise, the investor still gets his or her money back.

Another option is a short-term investment grade bond fund, such as Vanguard’s VFSIX or VCSH, which have a yield of nearly 2% and expense ratio of 0.10%. These funds are more liquid than individual bonds, although they can certainly lose value. With a duration of around 2.5-3.0, if interest rates rise 1%, then these funds should lose about 2.5-3.0% of their value, all other things being equal, and that is a reasonable expectation of potential annual downside risk right now although it has not lost money on an annual basis in the 5+ years it has been in existence. Although the funds invest in a larger range of individual bonds, including riskier ones, the funds are so spread out that the individual company default risk is minimal.

An alternative to a short-term investment grade bond fund is a floating-rate bond fund, such as FLOT, although it has a lower yield (currently 0.60%) than a short-term bond fund. Floating-rate bond funds invest in individual bonds that have a floating interest rate, usually tied to LIBOR, so as interest rates change, so will the fund’s yield. As a result, this fund has almost no interest rate risk, but higher default risk than government bonds or high quality individual bonds. In the aggregate, it is less risky than short-term corporate bond funds but riskier than short-term government bonds, and it has an expense ratio of 0.20%. What I like about floating rate bond funds is that their interest rates will quickly adapt to any change in the federal funds rate, so in a rising rate environment, these types of funds will much more quickly reap the rewards of higher interest rates than a traditional bond fund.

Finally, a more aggressive option is a bank loan fund such as BKLN, which has a much higher yield of around 4-5% (expense ratio of 0.65%), and very little interest rate risk because the loans roll over every 30-90 days.  It is risky because the fund holds high risk loans, albeit secured by property or equipment of the borrower. BKLN lost about 3% of its value in 2015, primarily because investors moved to safer investments and perhaps because of concerns about oil industry bonds, but it has returned an average of 4.39% over the past five years. Of course, 3% or greater losses can happen to any of the above-listed funds, in terms of interest rate changes, an increase in defaults, or market sentiment causing a decrease in demand, and therefore value, even if interest rates or default risk do not change.

The comparative risk of the different options is illustrated below:

thermometer snippet

While risk often corresponds to return, that is not always the case.  Right now, the interest rates on money market funds, floating rate bond funds, short-term government bond funds and near-expiration quality corporate bonds are so low, that you can do better with a money market account or CD as banks fight for deposits. Also, the relative return of the different investments is always changing, so this is yet another situation in which you do not want to fix your plan and forget about it for many years. All of the above listed funds can lose value, whether it is because of defaults, changes in interest rates or market sentiment.

For those of you wanting to consider an alternative to putting all of your emergency fund in a CD or money market account right now, here are two viable options:

  1. Keep enough cash in a money market account to cover everything but a job loss or other extreme event. The extra cash can be divided between VCSH and BKLN to get more yield based on your risk tolerance and understanding that both funds carry the risk of loss.
  2. Do the same as above, but implement a momentum strategy to determine where to put the extra cash. So long as VCSH or BKLN are above their 200 day moving average and have a greater yield than a money market account, then put your extra cash in one or both of those funds. If either’s price moves below their 200 day moving average or has a lower yield than a money market account, then put move the cash back to your money market account. This does not remove the risk of loss with the funds, but it should reduce the drawdowns in a situation in which we want to minimize risk.

These two options do not fit everyone’s situation or risk tolerance. Your plan should be carefully researched or discussed with an independent, fee-only adviser before implementing.

-Richard

Disclaimer

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