Several years ago, low interest rates sent fixed-income investors scrambling for higher yields, and many, including lots of small-business owners, were talked into auction-rate securities to earn a tad more. As the financial crisis gathered steam early in 2008, the auction-rate market froze, leaving investors unable to get at holdings that were supposed to be as safe and liquid as cash.
Earlier this week, New York’s attorney general, Andrew M. Cuomo, filed suit against Charles Schwab, trying to get the brokerage firm to return investors’ money. Schwab says it, too, was tricked into believing auction-rate securities were safer than they were, a similar claim made by a number of other firms that regulators have accused of deceiving investors.
The episode underscores the continuing problem for small-business owners who need to invest cash, whether it’s a reserve for the business, a rainy-day fund for personal use or part of a long-term diversification strategy: how to get the best yield without compromising safety. The problem is especially acute today, as tight-fisted lending standards drive many to keep larger-than-usual cash reserves.
So, where should you put that cash?
Given today’s conditions, I think it best to focus on safety and accessibility and not to worry too much about yield. Getting an extra quarter or half percentage point may be pleasing to the ego but doesn’t increase earnings very much — not when they’re counted in actual dollars. A $100,000 account earning 2 percent produces $2,000 a year. Is it really worth putting your principal at risk to get another $1,000 by earning 3 percent?
Lots of smart, experienced people were fooled by the “safe as cash” marketing come-ons for auction-rate securities. And, to be fair, it took an extraordinary crisis in the credit markets for that promise to be broken. But there were some red flags that offer a lesson for other types of holdings. Many of these products were new and untested in a down market. They depended on a continuing flow of willing buyers at regular auctions that set interest rates and provided a market for investors who wanted to pull their money out. It’s a safe bet that very few of the auction-rate investors really knew what they were getting into, and that’s a situation to be avoided in all investing.
Compare all that to a simple savings account or certificate of deposit: You put your money in, earn a known interest rate, and get your cash back whenever you want or after a stated interval. If the bank has problems, the federal government steps in to make sure you get all the principal and interest you are owed. Everyone understands how this system works.
Financial experts often talk about three main asset classes: stocks, bonds and cash. While money clearly should not go into stocks unless it can be tied up for at least five to 10 years, many investors don’t make a sharp distinction between bonds and cash. They are both interest-bearing holdings, and the tie-up period for cash holdings like C.D.’s can overlap with that for bonds.
So it does make sense to view cash and bonds as a continuum. Short-term holdings tend to be safe and liquid but low-yielding. As the tie-up period gets longer, holdings obviously get less liquid but yield more. Safety becomes a trickier issue. A five-year C.D. with Federal Deposit Insurance Corporation insurance is very safe, while a five-year corporate or government bond is a bit riskier, especially if you may have to sell early. In that case, no one will pay full price for your older bond if newer ones carry higher yields.
To deal with this sliding scale of safety, risk and yield, most experts recommend “laddering.” Money that must be immediately accessible is kept in savings, checking or money market accounts. Other money would go into C.D.’s or short-term bond holdings with varying maturities — three, six, nine, 12 and 24 months, and so forth. The longer the term, the higher the yield. The Internet has plenty of laddering calculators for devising these strategies.
Today, choices for cash investing are relatively simple to deal with, since you won’t earn much more by tying your money up for longer. Money market accounts, which provide great safety and immediate liquidity, carry average yields of 1.16 percent, according to the Times survey. Six-month C.D.’s yield 1.25 percent, one-year C.D.’s 1.6 percent, two-year ones 1.9 percent and five-year ones 2.64 percent.
With rates this low, you can keep your cash in a money market account with a clear conscience: There’s hardly anything to be gained by locking it up, though six- to 12-month C.D.’s are fine if you won’t need your money sooner.
Yes, you could more than double your earnings with a five-year C.D. But if yields rise in the meantime you’ll have the unpleasant choice of staying with a below-market yield or paying a penalty to get your money out to reinvest. Treasury securities aren’t very appealing. The two-year note pays just 1 percent. Corporate bonds are more generous, but with the economy still shaky they carry too much risk for cash holdings.
Because yields are so low today, there’s a better chance they will rise, not fall, especially as the economy seems to be perking up. That’s another reason to keep your money accessible in short-term holdings. Locking in for longer terms makes more sense only when the odds favor a reduction in rates. (For borrowers, the logic is the opposite: This is a good time to lock in a low-rate long-term mortgage.)
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