One of oldest adages in investing is “no risk, no return.” These days, that old saying seems literally true, since cash is considered the safest asset, yet it earns virtually no interest. However, in this article we'll examine whether cash is as safe as is sounds. Then, we'll look for where to get the most bang for your bucks.
The Not-Quite-so-New FDIC Limits
The first place, and perhaps the safest place, people turn to keep their cash is a bank to take advantage of FDIC insurance. The insured limit was raised from $100,000 to $250,000 during the financial crisis of 2008, and the increase was made permanent in 2010 by the Dodd-Frank bill. Additionally, through 2012, all non-interest-bearing accounts have unlimited coverage.
The limits apply to each “ownership category,” which includes single accounts, joint accounts, certain retirement accounts, and trusts, among others. So, you could have a single account in your name that is insured up to $250,000, your spouse could have a separate single account insured up to $250,000, and you both could have a joint account that has an additional $250,000 of coverage, for a total of $750,000 insured deposits (just in case you find a LOT of change in your sofa). Also, you get a whole new set of limits if you go to another bank — but it has to be a completely different bank, not just a different branch of the same bank. Use the Electronic Deposit Insurance Estimator (EDIE) at FDIC.gov to determine how much of your cash is covered.
Deposits at credit unions have nearly identical coverage through the National Credit Union Association. You can use the e-calculator at NCUA.gov to determine how much of your deposits are insured. Both FDIC and NCUA insurance are backed by the full faith and credit of Uncle Sam. That doesn't feel as safe as it used to, but the reality is that it's about as safe as you'll find in this world. Just make sure that your bank or credit union really is insured, which you can confirm at FDIC.gov and NCUA.gov.
The insurance extends to what are generally considered cash equivalents, such as checking accounts, savings accounts, money market deposit accounts, and certificates of deposit. The insurance does not cover investments such as stocks or bonds, nor does it cover money market funds, which are very different from money market accounts. What's the difference? We're glad you asked.
What's in a Money Market Fund?
A money market deposit account is essentially a savings account at a bank or credit union that allows for a limited number of checks to be written to third parties. A money market fund is a mutual fund run by a financial services firm, and it invests in short-term debt (with maturities of a year or less) from governments and corporations. Like every other mutual fund, there is no government guarantee behind a money market fund. However, every fund strives keep its net asset value at $1. There have been only two instances of funds “breaking the buck”: one in 1994 and one in 2008. Investors in these funds lost 2% to 8% of their principal.
Chances are, the cash in your brokerage account or IRA is in a money market fund. To see what's actually in the fund, you'll need to visit the website of the company that sponsors the fund. (Fund information providers such as Morningstar typically don't provide analysis of money market funds.) As an example, let's peer inside a fund from Fidelity, the largest provider of money market funds for retail investors. Almost half of the Fidelity Cash Reserves Fund (FDRXX) is in certificates of deposit, almost 12% in Treasuries or government agency debt, and more than 17% is in short-term debt (known as “commercial paper”) from financial companies. On average, the debt in the fund matures in 56 days.
What many investors might find surprising is that most money market funds have exposure to European debt, though funds have reduced their exposure from 30% at the end of May to 10% by the end of December, according to the Fitch rating service. Meanwhile, they've been increasing their holdings of U.S. government debt and repurchase agreements (a.k.a., “repos”), which are a form of secured lending and, thus, theoretically safer bets.
But as the name implies, repos include an agreement by which the seller agrees to buy back the security at a later date, at a certain price. If the seller can't honor the agreement, the buyer — in this case, the money market fund — is stuck with the debt instrument at whatever the price the market is willing to pay for it. The Fidelity Cash Reserves Fund has almost 20% of its assets in repos. The T. Rowe Price U.S. Treasury Money Fund (PRTXX), which you'd think — given the name — is invested just in U.S. Treasuries, actually has more than a third of its assets in repos. The fund's fifth-biggest holding is debt from General Electric.
As long as the global economy functions in a somewhat normal (albeit slow) manner, money market funds are very safe. However, if there was another “black swan” event such as we experienced in 2008, it would not be a surprise if a few more money market funds “break the buck.”
Where to Turn
We don't want to overstate the risks of money market funds; the vast majority will maintain a $1 NAV. However, given their low yields — the Fidelity Cash Reserves Fund yields a whopping 0.02% — there are few compelling reasons to say with a money market fund, especially if you don't need the money in the near term. Financial planner and columnist Allan Roth has written about choosing higher-yielding, longer-term CDs. Even if you have to pay a penalty for getting your money back early, it's worth getting the extra yield, as long as you can leave the money alone for approximately two years (depending on the yield and early withdrawal penalty). To find the best rates, check out the GRS CD rate finder, which monitors more than 200 banks and displays the 50 highest rates. There's no reason to get virtually no yield from a money market fund, when you can get 1% to 2% or higher from a CD that enjoys FDIC or NCUA insurance. That's the kind of risk-reward proposition we like most.
Where do you keep your cash? Know of any banks or credit unions offering particularly good rates? Let us know in the comments.