With money market accounts paying essentially 0%, what's a saver to do?
A couple of years ago, I wrote a series of posts on saving for emergencies: why you need an emergency fund, how much you need to have in an emergency fund, and where to invest your emergency fund savings.
Although the first two articles are still relevant, the last one – on where to invest emergency funds – needs some updating.
In the fall of 2008, people were complaining about the fact that one-year CDs were only providing returns of 4%. Today, with five-year CDs yielding 2 1/2% or less, those rates look pretty good. Money market fund yields are so low that money fund managers should be ashamed to show their faces in public; one well-known fund is currently yielding 0.06%, with an expense ratio of 0.23% – and that expense ratio is low relative to others I’ve seen.
Prospects for emergency fund savers are thus pretty slim. An FDIC insured online savings account these days yields about 1%. Since the whole point of an emergency fund is to provide a financial cushion during a crisis, the ideal place to put the funds would be an ultra-low-risk account. Given how poorly those are yielding, some savers are starting to wonder if they should take on a bit more risk and stretch for a higher return.
High-Interest Rate Checking AccountsBefore considering higher-risk, non-FDIC insured accounts, a possibility worth considering is a high-interest rate checking account. There are credit unions and community banks all over the country offering these accounts with yields as high as 3%.
In order to receive the highest rate, you must meet certain criteria. The accounts usually require that you make a certain number of debit card purchases each month, have at least one direct deposit or automatic bill payment each month, and receive your statement electronically. There’s one more catch: the highest rates apply to a maximum balance that’s typically $10,000 or less (though some accounts have higher maximums). The portion of your account balance that exceeds the maximum amount receives a lower rate, usually on the order of 0.5%. You can search by location for a high-interest rate checking account at http://www.checkingfinder.com.
Since these accounts must be used for transactions each month in order to qualify for the higher interest rates, such an account would need to function as both your emergency fund and as your active checking account. Unlike a separate account that you don’t touch except for emergencies, you’d have to impose your own discipline to avoid spending the “emergency fund” portion of the account (unless it’s really an emergency). Some people would have a hard time doing this – it’s often easier psychologically to avoid touching money that’s kept in a separate “bin.” Still, for some people these accounts could be an acceptable emergency account solution.
Riskier OptionsFor many people, a high-interest checking account is the best solution for emergency fund savings. But what if you need to set aside more than $10,000 in emergency funds? Depending on how much you need to have in your emergency fund, you could easily exceed this limit.
In the present low-interest-rate environment, a higher return will require taking on more risk than an FDIC-insured account. I don’t think that this is the right approach for everyone; for example, if you need to keep money set aside that you intend to use as a down payment for a house in six months, you don’t want to take even a small risk of losing 5-10% suddenly. But some people might be willing to take that kind of risk with a portion of their emergency funds.
For an investor willing to keep an eye on the direction of interest rates, there are other options. They involve some risk of a loss of principal, unlike an insured savings account. But they aren’t as risky as investing in the stock market. Let me suggest a couple of options.
GNMA FundsThe least-risky option, in my opinion, would be a mutual fund that invests in securities issued by the Government National Mortgage Association (GNMA), usually referred to as Ginnie Maes. Although these are mortgage-backed securities, they are backed by a government guarantee, so they are viewed as presenting no credit risk. What they do possess is interest-rate risk, plus the possibility that mortgage holders will pay their mortgages off early. If interest rates rise, the value of a GNMA fund will drop. Thus investors in these funds are taking a risk of principal losses when interest rates are at historic lows.
In practice, if you wish to use a GNMA fund for some of your emergency funds, you should look for a fund with a short “average duration,” meaning that it’s less sensitive to variations in interest rates. For example, the share price of a fund with an average duration of 4 years will tend to fall about 4% if prevailing interest rates suddenly rise by one percentage point, while the price of a fund with a 2-year duration would fall half as much. Look for a fund with low fees (less than 0.4%) and an average duration of less than 5 years. Then keep an eye out for the direction of interest rates; if they start to rise significantly, it may be time to find somewhere else for your emergency funds. GNMA funds are currently yielding about 3%. If you have $50K to invest, you can use Vanguard’s Admiral-class GNMA fund, which sports a super-low expense rate of 0.11% - lower than most money-market funds.
Bank Loan FundsNow we come to the riskier option. Bank loans, also known as floating-rate loans, are issued to corporate borrowers with less than sterling credit ratings. These loans bear interest rates that are adjustable, and the rates are typically pegged to the London Interbank Offered Rate (LIBOR), the prime rate, or some similar benchmark. Bank loan interest rates adjust with a frequency that ranges from 30 to 90 days. For this reason, funds that invest in this type of loan tend to perform well during periods of rising interest rates, as their returns rise with rising interest rates.
Normally, the main risk in a bank loan fund is the possibility that one or more of the companies whose debt is owned will default on its debt. This risk is mitigated by at least two factors. First, a bank loan mutual fund typically holds loans from hundreds of different companies, so the default of two or three should have a tiny effect on the total value of the fund. The second factor is the fact that bank rate loans are typically secured by cash or assets, and the loans take precedence over other forms of debt issued by a company. In the event of a default, bank loan holders are paid before bondholders. Historically, in a default bank loan investors are repaid at a rate of 75 to 80% of the value of the loan.
Still, there are additional risks associated with these funds in some circumstances. Between the middle and the end of 2008, fears about the extent of the financial crisis drove bank loan fund prices down an average of 30%; some fund prices did not recover for 6 - 12 months. The funds continued to make interest payments during that period, but a drop of that magnitude would have produced serious losses for anyone who needed to cash out of the funds during that period. There are also closed-end bank loan funds that can use leverage to amplify their yields; these present additional risk when things go badly.
If you do choose to put a portion of your emergency funds into a bank loan mutual fund, recognize that it is a risky option, don’t overextend yourself, and be sure to research your fund choice carefully. Funds with higher-quality loans provide current yields of about 3.25% with the potential for higher yields if rates rise, but these funds also present risks of price declines. As always, look for funds with low expense ratios – less than 0.75% is about right.
As I’ve said before, there is no one-size-fits-all solution to the question of where to invest your emergency funds. The important thing to remember, especially in the current economic climate, is not to get greedy and take larger risks than you can afford.
Disclosure: Invested in Vanguard GNMA Admiral Fund.