Interest rates have been low for years, dramatically impacting anyone who must hold a large position in cash. There may be several reasons why you need to hold a large cash position, perhaps you have some anticipated large expense looming, or you need to have a large cash reserve for an emergency. You might have thousands of dollars in cash, earning .25% in a money market account. Can you earn more?
Here are some of the investments you might consider and why they may not be good choices.
Floating Rate Loan funds – are funds that invest in bank loans, very often those that are below investment grade. Right now, some of these funds have yields that range from 4-6%, a huge improvement over a money market fund. Unfortunately, these types of funds are subject to more risk than one would expect. In 2008 when markets were crashing some of these funds also declined in value by 25-30%. During a financial crisis, the default rate for the loans these funds hold can also skyrocket and impact return. Exposure to that amount of risk is not what you want for your cash reserves.
High Yield Bond funds – High yield bonds are generally considered to be bonds that are rated BB or lower by S&P or Ba by Moody’s. They have historically provided high income over the years. Like every other class of bond, yields are now low when compared to their historical yield; yet their risk has not decreased. Like floating rate loan funds, in 2008 high yield bond’s return was -28%, illustrating how risky this asset class is during economic slowdowns or financial crises. Like floating rate loans their default rate also tends to rise dramatically during recessions.
Longer Term Bond ETF’s – May have a much higher yield than a money market account but they come with much greater risk not from defaults (for government bond funds or high-quality corporate’s) but instead from increasing interest rates. The market value of the bonds they hold can be quite sensitive to interest rate changes. For example, Vanguard’s Long-Term Government Bond ETF (VGLT) lost 1.8% for the prior year ending 5/31/2017. That includes it’s yield which is around 2.7% right now. If interest rates rise long term bond funds can easily have negative returns as high as 6% in one year, since the bonds they buy may decline in value that much or more for each 1% increase in interest rates.
Preferred Stock Funds – Companies may issue several classes of stock including common stock and preferred stock. Preferred stock is issued with a fixed and typically high dividend, right now yields are in the 4-6% range. If a company is liquidated preferred shareholders receive whatever is left after bond holders are reimbursed but before common stockholders. Preferred stock has much of the risk of common stock since it is effectively an unsecured debt (unlike a bond) but it lacks the potential for growth since the dividend is fixed and the preferred stock may also be callable. Because of these features we do not believe it is a good investment for most people. In a bad market, preferred stock acts like common stock. In one case, an ETF that invests in preferred stock dropped 61% from May 2007 to March 2009.
While this list is not complete, we hope we’ve given you a feel for the risks you may encounter in trying to get more yield. You increase your exposure to types of risk that generally do not exist with a money market account. Those risks in summary include, market risk, interest rate risk, and default risk. When we consider these options, I recall something a professor wrote on the black board when I was getting my Masters in Finance: TINSTAAFL. None of us could guess what the heck that meant until he told us: There Is No Such Thing as A Free Lunch.
Stephen Craffen & Laura Mattia