Too Much Low Yielding Cash

[sdfire]

I'm a little embarrassed to admit that I've allowed a large amount of cash to build up in my tax exempt money market account now yielding .17%. Part of the reason that I've built up this amount is that every time I plan to buy a true bond fund I end up talking myself out of it because of a fear that interest rates will go up and hurt my return. My non-equities are largely held in a combination of Savings bonds (I have some yielding 9% right now--woo hoo), CD's, and tax exempt money market accounts. I would like to move a big chunk of cash into something relatively safe that will yield far more than .17%--sheesh. As I said, I have a probably irrational fear of interest rate increases eating away at bond fund returns. I've considered buying individual muni-bonds, but I'm not entirely sure how to make that happen and I fear that my bond picking expertise would pale against the fund managers who I am afraid will lose yield if interest rates increase. Hence, I've done nothing for the most part and that is crazy.

This is all a long way of asking: what do you recommend for the non-equity portion of your portfolio and are there web or other resources that I could use to come up to speed on the options?

Thanks!

 

[calmloki]

Think you can pick up a point and a half with Capitol One savings account. That's quick and easy. Oh - tax exempt, well make an extra point anyway.

 

[brewer12345]

I would look at a medium duration muni bond fund (no more duration than 5 years or so) or at an intermediate investment grade corporate bond fund. I believe Vanguard has both. Bonds with maturities in the 4 to 7 year maturity range aren't that susceptible to interest rate increases and you will pick up a lot more yield. Alternatively, you could look at something like Pen Fed's 5 year CD. If rates pop, you can always cash in the CD early for a penalty of 6 months worth of interest and in the meantime you pick up a lot more yield than you are getting.

I personally own a wad of 5 to 9 year maturity corporates in the form of individual BBB and A rated bonds, but you have to be able to do credit work to realistically do that.

 

[ksr]

I personally own a wad of 5 to 9 year maturity corporates in the form of individual BBB and A rated bonds, but you have to be able to do credit work to realistically do that.

Would you mind explaining this a little more? Bonds are the area I'm least knowledgeable of, and am eager to learn more.

 

[FIREd]

I personally use Vanguard's short term tax exempt fund (VWSTX) for my "safe" money. The NAV is very stable. It pays more than the tax exempt money market fund and the principal should not be overly impacted by rising interest rates. But right now, it looks like Vanguard's intermediate term tax exempt fund (VWITX) is in the "sweet spot" and that's where I have most of my tax exempt bond money. I will probably move that money to VWSTX if/when the yield curve starts flattening.

 

[Darryl]

20yr TIPS are over 2.25% real return. Bank&CU specials on CD's savings or checkings can run to 6% you just have to look around.

 

[Buckeye]

Dollarsavingsdirect.com is paying 1.7% with a minimum balance of $1,000. You can take your money out via transfer when you want it. It's just a savings account (online only) so there is no commitment. You have to link with a checking account to receive/initiate the transfer but that shouldn't be a problem.

 

[sdfire]

Thanks for all of the helpful thoughts. Let me clarify that I am looking for ideas for putting cash to work in the non-equity side of my portfolio. I will probably keep some of my cash that needs to stay cash in my tax exempt money market just because that is easy and very safe. But, I've got way to much there and I need to put the extra to work better. So far, I'm thinking about the suggestions for intermediate bond funds (I have cash at both Vanguard and Fidelity so I could easily purchase a bond fund at either company). How do you decide which term and fund? I don't want to move a bunch of cash into a fund and then learn that with rising interest rates I would have been better to sit things out and buy a CD or something. The other suggestion that I've always considered but never known how to implement is purchasing muni bonds. Is there a website that walks you through this or would someone be willing to take the time to explain how they do it?

Thanks again!

 

[W2R]

During our 2008 "roller coaster ride", I maintained a lot in cash as well. In April, I put some into an bond index fund, VBMFX Vanguard Total Bond Market Index Fund. Works for me.

If you want to read about the pros and cons of various types of bond funds and how to set up your bond allocation, I really like Rick Ferri's discussion in his book All About Asset Allocation. Now that the market seems to be settling down a little, I need to re-read it too.

 

[FIREd]

How do you decide which term and fund? I don't want to move a bunch of cash into a fund and then learn that with rising interest rates I would have been better to sit things out and buy a CD or something.

To determine which fund to buy, I use what is called a "shifting maturity" strategy. In other words, I look at Vanguard's tax exempt fund line up, plot the SEC Yield Vs. average maturity for the 4 funds available (short term, limited term, intermediate term and long term) and I find the inflection point on that curve, i.e. the "sweet spot", or the point that offers the greatest total return.

If finding the inflection point on a graph is not your cup of tea, another way to do it is to measure the slope between two consecutive data point. I use a cutoff of 0.2, so if the slope between 2 consecutive data points is >0.2, I pick the fund with the higher maturity, and if it is <0.2, I pick the fund with the lower maturity. On my spreadsheet below, you can see that the slope between the short term fund and limited term term is currently 0.47, so I would pick the limited term fund over the short term fund. Then, the slope between the limited term fund and intermediate term fund is 0.36, so I would pick the intermediate term fund over the limited term fund. And the slope between the intermediate term fund and long term fund is 0.18, so I would pick the intermediate term fund again over the long term fund. Therefore the fund offering the highest return right now is the intermediate term fund.

As the Fed starts raising short term interest rates, the yield curve should start flattening out and I might have to jump to the limited term or even short term fund to get the higher return. That's why it's called a "shifting maturity" strategy. It's not exactly a set it and forget it approach...

 

[kaneohe]

The other suggestion that I've always considered but never known how to implement is purchasing muni bonds. Is there a website that walks you through this or would someone be willing to take the time to explain how they do it?

First, you may want to decide on muni vs taxable
(depends on relative yields of each and your tax bracket) to decide which gives you best after-tax results. Then you may want to think about individual bonds vs funds https://personal.vanguard.com/us/Va...and_Views/news_ALL_munibonds_12232008_ALL.jsp

If you still want to do individual munis, brokers like Schwab carry them. Some things to consider:
1) Buy state general obligation munis (vs local entity--city/county/district vs revenue) for possible greater safety.
2) Buy on initial offering (vs secondary market) for lower (or no?) transaction costs
3) Buy own state munis (vs other state) for possible
no state tax on muni interest (but less diversification may create more risk)
4) Best if you are doing this for the income and expect to hold to maturity. Selling small lots may result in relatively large fees and lower yields significantly and also risk principal loss if interest rates increase.

 

[ksr]

To determine which fund to buy, I use what is called a "shifting maturity" strategy. In other words, I look at Vanguard's tax exempt fund line up, plot the SEC Yield Vs. average maturity for the 4 funds available (short term, limited term, intermediate term and long term) and I find the inflection point on that curve, i.e. the "sweet spot", or the point that offers the greatest total return.

I know you were responding to someone else, but I just want to jump in and say thanks for such a clear and concise explanation. This has helped to de-mystify the "yield-curve" jargon I often hear in the news.

I see how you do the math, but am curious about the inflection point on the curve. Is this something you just eyeball, or is there a more scientific approach to finding it (other than doing the math, which is probably the route I'd go)? Thanks!

 

[FIREd]

I know you were responding to someone else, but I just want to jump in and say thanks for such a clear and concise explanation. This has helped to de-mystify the "yield-curve" jargon I often hear in the news.

I see how you do the math, but am curious about the inflection point on the curve. Is this something you just eyeball, or is there a more scientific approach to finding it (other than doing the math, which is probably the route I'd go)? Thanks!

You can do it the crude way: draw a couple of tangents and see where they intersect (see graph below). That's the way I do it. If you are mathematically inclined, I suppose you could try to fit the yield curve, figure out the corresponding equation and then take the derivative.

 

[kaneohe]

FD.......what's the origin/significance of the 0.2 slope decision criterion? I understand intuitively that there is a law of diminishing returns factor here similar to buying
a Toyota Camry in its various models vs a Lexus but I'm trying to understand the quantitative aspect.

 

[FIREd]

FD.......what's the origin/significance of the 0.2 slope decision criterion? I understand intuitively that there is a law of diminishing returns factor here similar to buying
a Toyota Camry in its various models vs a Lexus but I'm trying to understand the quantitative aspect.

0.2 is an arbitrary choice, i.e. a bond would have to yield an extra 0.2% for each year of extra maturity before I would consider investing in it. Of course, you might be satisfied with only an extra 0.15% or 0.1%. It's really a decision YOU have to make.

But it seems like 0.2 is used by a number of pros, including DFA funds from what I understand. Some people argue that, for munis, 0.15 or 0.17 would be more appropriate because of their tax exemption. But I personally do not favor longer term maturities (because of their stronger corrolation to stocks), and would only consider investing in them if they made a truly compelling invesment. To that end, I think that 0.2 creates a high enough hurdle to clear in order to avoid overextending maturities. It keeps me on the shorter end of the curve except if long term bonds become screaming buys.

 

[ksr]

If you are mathematically inclined, I suppose you could try to fit the yield curve, figure out the corresponding the equation and then take the derivative.

I might have been able to do this back when I was taking high school and college math, but now - not so much. I'm happy to just calculate the numbers as you showed in your first example. Thanks very much for the explanations.

 

[Lsbcal]

Just a point about bond maturities -- you should understand the concept of duration. If you're going to use a shifting maturity strategy or whatever, you should probably plan on holding the bonds for their duration (roughly speaking). Also the risk of gains/losses is linked to the duration of the bond or bond fund. Higher duration, generally higher yield but more sensitive to interest rate changes. Even though you may be getting paid to go out longer you are taking on more "term risk".

Finally, corporates have some equity like characteristics which means they will be more correlated with equities then Treasurys over the long haul. Not saying one shouldn't buy them, but one should understand the risks in any bond investment.

Just a few thoughts. I'd recommend Swedroe's bond book for more thorough discussion.

 

[brewer12345]

Would you mind explaining this a little more? Bonds are the area I'm least knowledgeable of, and am eager to learn more.

Sure, what do you want to know? I mention credit work because corporates in the BBB range definately have some credit risk and if you do not have the ability to determine whether the risk is modest or not, you could wind up with some very risky stuff. In that case, it is better to buy a fund.

 

[Dawg52]

Sure, what do you want to know? I mention credit work because corporates in the BBB range definately have some credit risk and if you do not have the ability to determine whether the risk is modest or not, you could wind up with some very risky stuff. In that case, it is better to buy a fund.

Probably for most of us, that is the better way.

 

[brewer12345]

Probably for most of us, that is the better way.

Very likely. I can distinguish between the dozen or so Bermuda reinsurers as far as creditworthiness, but I imagine its a closed book to many.

 

[ksr]

Sure, what do you want to know? I mention credit work because corporates in the BBB range definately have some credit risk and if you do not have the ability to determine whether the risk is modest or not, you could wind up with some very risky stuff. In that case, it is better to buy a fund.

Well, I'm curious how you evaluate risk and then how you decide what that risk is worth. I realize this is probably a complicated and somewhat individual analysis. Is it similar to evaluating a company before purchasing a stock (like looking at balance sheets, financial statements), or is there a whole new set of criteria for evaluating a corporate bond's risk?

Thanks.

 

[brewer12345]

Well, I'm curious how you evaluate risk and then how you decide what that risk is worth. I realize this is probably a complicated and somewhat individual analysis. Is it similar to evaluating a company before purchasing a stock (like looking at balance sheets, financial statements), or is there a whole new set of criteria for evaluating a corporate bond's risk?

Thanks.

It is similar to evaluating an issuer's financials for an equity purchase, but with a different slant. When I am evaluating a non-financial credit, I want to see how stable cash flow generation has been in the past, how much cap ex is required to maintain and grow the business, and how much cash is left over to service debt and pay it off as it comes due. I also want to have a good picture of the maturity schedule of all bank debt, bonds, secured financing, leases, etc. to determine whether the company has a specific date at which point its balance sheet could blow up (inability to refinance). I look for contingent liabilities that could imperil creditworthiness (lawsuits, environmental liabilities, patent issues, union/pension issues, etc.). I look at management and at who the principal owners/stakeholders are to see how they are likely to treat bondholders. Finally, I read the terms of the bond closely to figure out how the bondholders could get hurt due to the structure of the bonds. Then you have to do all the normal stuff to understand the industry and the company's place in the industry.

For financials it varies tremendously by sector. Most of my exposure there is to reinsurers and property-casualty insurers, so I will use them as an illustration. Aside from determining that the company is not too levered, the main thing I concentrate on is making sure that the company generates profits from underwriting (and not just from collecting interest) and that their reserves for future losses are appropriately conservative. In addition, I want to see how volatile the company's results have been. So a company like IPCR (exclusively catastrophe reinsurance) is a lot more volatile than AXS (multiline and does both insurance and reinsurance) or CB (multiline insurer). You also have to look carefully at their investment portfolios, but the Bermuda reinsurers and most of the onshore property-casualty insurers went into the current mess with pretty conservative portfolios and generaly modest leverage, so there usually isn't much to get worked up over there.

How do I determine what I need to be paid to hold the bonds? For good quality BBB and A rated names, I want 3% or more over treasuries for the 5 to 9 year maturities I usually look at, at least to consider holding the bonds. I usually buy when the spreads are significantly wider (I piled into these bonds at north of 10% YTM). I sell when the bonds get to par or where I think the risk is geting underpriced. But be aware that it is more of a challenge to sell bonds, especially at the retail level.

 

[Helen]

I probably should have posted the OP's question a few weeks ago. I had a chunk of change sitting in a taxable Vanguard MMF; it made less than 1% interest last year. I noted that the pssst Wellesley fund only lost 3% YTD (as of a few weeks ago) which is really good considering the blood bath the market took. I moved this money (that I'll need in 6+ years) to Wellesley.

I think I'll put all new money in a Vanguard short term bond fund. This new money will be used four and five years from now.

 

[ksr]

It is similar to evaluating an issuer's financials for an equity purchase, but with a different slant.

Thanks so much for the detailed reply. I found this very interesting, but I have to admit a bit overwhelming for me as well. While I am reasonably knowledgeable of the stock market and individual stock analysis, I think I'd be getting in over my head if I tried to evaluate bond risk. Probably a good reason for me to stick with bond funds and/or the higher-rated (less risky) individual bonds.

 

[Dennis]

Sorry, but I followed the advice of Paul Merriman and Scott Burns..
07'> Treasuries-Short, Intermediate and LT's
08'> VSGBX & Treasuries ( Sell if & when hits +10% )
09'> Sell Treas and Go into VFSTX and FFRHX( Sell if/when hits +15% )

They said the same ( Treas) for the last Bear of 00-02' )

I wouldn't trust Muni's.. They are too shakey.. Principal might be Insured, but not the Interest... or might get a IOU..

and If I can make 7-15% ave 11% - 28% = still netting 7.9%

and oddly enough? For my LT Bonds? TGBAX and FNMIX have outperformed all my other Bonds by almost double apy the past 10 yrs now..and Gold ( USAGX) has gone off the Charts for the past 10 yrs..

PIMCO just opened a new Bond Fund for The Little guy with $1k Min. req'd> PUBDX and PGSDX.