Tips for Wringing More From Your Cash Holdings

Just five short years ago, it was possible to pocket a return of 5% on your cash holdings. That's right--a 5% return for taking no risk whatsoever. It seems like a lifetime ago, doesn't it?

Now, with the Federal Reserve indicating it will keep interest rates low through at least mid-2013, you're lucky to earn a positive return on your cash, generally defined as money held in certificates of deposit, money market accounts and funds, and checking and savings accounts.

With that backdrop, many investors view cash as a necessary evil: They need it to cover emergency expenses or to pay living expenses if they're retired, but they're not likely to make anything on their investments, particularly once inflation is factored in.

To find out if any Morningstar.com investors had hit on solid strategies for obtaining slightly higher yields from their cash holdings, I posted a query in the Income & Dividend Investing forum of Morningstar.com's Discuss boards. No responders offered a magic formula for wringing higher yields from true cash vehicles (unfortunately!), but several offered practical tips, including online banks, credit unions, and building a multitiered cash/cashlike account. Other posters noted that they've been willing to venture beyond true cash in an effort to pick up a higher payout, sparking a discussion about the pros and cons of such a strategy. To read the complete thread or share your own approach to your cash holdings, click here.

'Ziploc Bags Do Well'
In response to my query, several posters discussed the sad state of affairs for cash holders. Konodrum quipped, "I bury cash or stuff it in the mattress. Ziploc bags do well."

FidlStix is also keeping his sense of humor, even as he acknowledges that the landscape has become a challenge for retirees and anyone else attempting to wring a return from low-risk assets. "I recently went to my local hardware store to buy two stainless-steel buckets for my shorter-term retirement needs. I prefer stainless because it's practically corrosion proof and stays shiny longer. Sadly, all they had were cheerless, gray galvanized buckets with holes in the bottom." 

Even as they lamented the ultralow yields available on cash, however, posters noted that they weren't inclined to venture further afield with the so-called safe portion of their portfolios. Chief K wrote, "I have almost 90% of my cash in online bank savings accounts ( ING (ING)--Orange Bank) that pays considerably more than most cash accounts but still not enough more to brag about. The remainder of my cash languishes in my checking account and its linked savings account. My cash accounts represent money I'm sure I'll be spending within the next 36 months--convenience, accessibility, and safety are trumps for me."

Weiwentg holds cash as dry powder for when great opportunities arise in individual companies. "Even the best CD rates aren't a lot over 1%. I figure the market will be disrupted for some time. I figure I might as well keep the cash on the sidelines. I'll have the opportunity to pounce on an oversold stock. For example, I bought  Health Care REIT (HCN)."

For AtTheBeach, cash helps balance out higher-risk, income-producing securities elsewhere in the portfolio. "As recent retirees, we spent 2011 putting our money in place for income investing. Interesting timing. To earn 5%-6%, we've had to take on more risk than we'd planned, so we are very happy having our cash cushion (currently 17%)."

'1% Savings Rates and No Hoops'
In terms of options for a higher yield on true cash, online banking accounts received frequent mentions.

Darwinian wrote, " Capital One (COF) online bank pays 1.21%, FDIC insured, minimum balance $1,000 if you have their credit card (which has no exchange fees on international purchases)." He went on, "I used to use  Vanguard Short-Term Tax-Exempt (VWSTX), Vanguard's ultra-short-term muni fund, as a cash substitute. But, it now pays no better interest rate than Capital One, to offset its (rare and small) risk of price decline."

Dclemons also looks to online banks for cash holdings. He wrote, "ING's Orange money market account invests in commercial paper, as does  Zion's (ZION) Internet money market account. Those kinds of accounts restrict the amount of withdrawals the investor can make each month. Both make electronic transfers back and forth from checking easy." 

Cgkems touted accounts at  American Express (AXP) FSB and  Discover Financial Services (DFS), writing, "1% savings rates [and] no hoops."

Cgkerns, likes others, also looks to credit unions to pick up a somewhat higher cash yield than is available at commercial banks. The favorite, according to this poster? "Alliant Credit Union has 1.1% checking and 1.15% savings rates and no hoops to jump through. Almost anyone can qualify for membership, and it has great loan rates too." Of all his picks for cash, cgkems wrote, "These institutions don't use teaser rates to attract your cash. Their rates adjust up as short-term rates increase." 

Atlasandgalt, meanwhile, urges a laddered approach to CDs, writing, "Ladder your CDs over a five-year period and pick the highest (FDIC) bank, such as Ally, USAA, ING, and so on. It can always be cashed in with little penalty if necessary."

Bubbygator likes a laddered strategy in principle but notes that it can have drawbacks. "Laddering CDs is a great idea--for when the interest rate is high enough. I'm looking forward to high rates, but I think it will be awhile. I found that laddering CDs was not as practical, as all I checked, including Ally and ING, have now changed their penalties for new accounts; that wipes out most of the interest accumulated for early withdrawal."

Bnorthrop, meanwhile, has been using the stable-value option in his 403(b) to help fill out the cash portion of his asset-allocation plan, writing, "The bulk of my cash is sitting in a 403(b) stable-value fund earning a bit north of 3%. While the investments are actually high-quality short-/mid-term bonds, the principal has never declined. This money will be available to me without penalty in less than two years and will be used as a source of cash when needed." (Stable-value funds don't offer liquidity for those not taking retirement plan distributions, but they do typically offer higher yields than are available from other cash vehicles.)

'Both Buckets Will Likely Be Leaky'
Other posters noted that they're using a two-part fund for their liquid holdings--one part entirely liquid assets and the other slice in higher-yielding investments that come with slightly higher risk and/or less liquidity.

Buckstopshere's two-part approach combines cash with i-bonds. The i-bonds aren't as liquid as cash, but they preserve real purchasing power. "I divide cash into cash needed-to-pay expenses and a cash reserve. For the former, I think the best option is still the money market fund--either taxable or tax-exempt as appropriate. For the cash reserve, in my humble opinion the best option is Series I savings bonds purchased through TreasuryDirect. The value of an i-Bond cannot drop below its purchase price, so it is cash. There are no commissions to purchase or sell i-Bonds. Interest paid on the bonds is tax-deferred (no taxes until bonds are sold). No risk of loss. A major risk for cash investments is inflation, and returns on i-Bonds are inflation-adjusted (similar to Treasury Inflation-Protected Securities). The disadvantages are one, cash put into i-bonds cannot be withdrawn for one year, and two, there's an annual purchase limit of $5,000. For long-term investors like me, these disadvantages are minor."

Poster Cherie and her spouse are also using a two-bucket approach to managing the liquid portion of their portfolio. Like buckstopshere, risk control is top-of-mind, despite fairly meager yields currently. "My husband and I have two 'buckets' of cash: liquidity savings and 'early retirement' savings. Since the liquidity savings account is meant to provide for the immediate funding of whatever larger expenses may come up, we keep this in a savings account (tied to checking) that earns only 30 basis points, which I view as the price for having liquidity and peace of mind." 

She went on, "The early retirement savings is meant to provide for our living expenses during ages 55-60, before we have access to IRAs, 401(k)s, and pension. (We are 49). All this cash is at Ally Bank in the form of online savings, and laddered CDs out to five years. I do not want to use bond mutual funds for this cash bucket because of the expenses and potential loss of principal when rates begin to increase. Given the purpose of this cash, liquidity and preservation of capital trumps any incremental increase in returns that other investments may offer."

Other posters, meanwhile, have been willing to take on extra risk with part two of their liquidity funds, pairing cash with bond funds. In exchange for the risk of principal loss that accompanies the bond holdings, they receive a bit of extra income. Kbisles outlined the following approach: "We use an FDIC-insured bank which yields 2.65% checking and a 1% savings yield. We just have three requirements to meet, including check card usage, a direct deposit, and statements printed online. They are safe. In addition we have a short-term bond index fund and TIPS, (a little more risk) for what we call our fixed-income assets."

AndThat employs a similar strategy, albeit one with more holdings. "For my cash-on-hand balances, I use a combination of about a 75% savings accounts with 'decent' yields (ING and my credit union), and the rest in 'safe-ish' bond funds. I definitely like  Fidelity GNMA (FGMNX), which I get transaction-[fee]-free as Fidelity is our 403(b) provider. I also use a bit of  Fidelity Government Income (FGOVX),  Fidelity Spartan U.S. Bond Index ,  Fidelity New Markets Income (FNMIX), and  Fidelity Inflation-Protected Bond ."

JHAsheville pairs true cash holdings with bond funds, including  Vanguard High-Yield Tax-Exempt (VWAHX),  Vanguard Short-Term Investment-Grade (VFSTX), and  Vanguard GNMA (VFIIX). FidlStix, using the bucket approach to retirement planning, is also employing both cash and bonds. "I'm planning to set up in 2012 two buckets for shorter-term retirement spending. Both buckets will likely be leaky, since few so-called safe' bond funds (short-term/U. S. government) sport yields that keep up with real inflation of 5%-7%. My nearer-term bucket will probably hold about 50% cash and the rest in a short-term/government bond fund like  T. Rowe Price Short-Term (PRWBX) or  T. Rowe Price GNMA (PRGMX), to cover 18-24 months of expenses. My medium-term bucket will hold mostly somewhat-riskier AA or AAA bond funds and a little cash." 

'Don't Endanger Your Safe Money Out of Frustration'
Other posters have been willing to forgo cash altogether and have instead opted for bonds, sparking a discussion about the safety of such an approach. Funds focused on the GNMA sector received repeat mentions as worthwhile holdings for liquid reserves.

Yogibearbull mentioned two exchange-traded funds that are just a few steps beyond true cash,  PIMCO Enhanced Short Maturity Strategy (MINT) and Legg Mason's forthcoming ultra-short-duration ETF. Bardofinvesting is using a TIPS ETF along with a short-term TIPS fund to help reduce interest-rate sensitivity. He writes, "Because both  iShares Barclays TIPS Bond (TIP), and  iShares Barclays 0-5 Years TIPS Bond (STIP) are ETFs, I can sell them and instantly to buy stocks in a sudden 'down' market so typical nowadays. Mutual funds of course can't be used this way because you have to wait overnight to sell them when the market has already closed."

Knobby62, meanwhile, is being way more aggressive with his cash pool. "I know few will agree with this, but I put my cash into  DoubleLine Total Return Bond (DLTNX)." Enthusing about the fund's lush yield and manager Jeffrey Gundlach's performance in challenging environments, he wrote, "I may regret it some day, but I feel my cash is safe with Gundlach. And this has been a volatile market."

Bubbygator, meanwhile, was one of several posters enthusing about GNMA funds as a parking place for short-term assets. Of Fidelity's GNMA fund he wrote, "It came through the 2003-06 period of increasing rates without a big dip, and it came through the 2008 credit-scare recession with barely a blip. Current yield is 3.19%, a Morningstar Rating for funds of 5 stars and a Morningstar Analyst Rating of Gold. Its 12-month rolling returns have been positive for 10 years except for a small negative two months in mid-2005.”

Darwinian prefers Vanguard GNMA and likes the asset class overall, but warns about using such a fund to meet near-term cash needs. "I am somewhat disturbed that many of the respondents here do not seem to have a clear idea of what the term 'cash' means. This term is properly reserved for the contents of the bucket that you might need to empty at any time, perhaps within the next few months, to meet an unavoidable short-term need. GNMA funds such as Vanguard GNMA are excellent choices for one- or two-year time frames, but they are not cash.  Vanguard GNMA once lost 8.5% over just three months, and it has several times lost 3% or more. This is not a very good trade-off for a fund that pays less than 2% more interest than you can get from an FDIC-insured account." 

Other posters concurred that it's better to be safe than sorry when it comes to money you need to tap in the near future.

Joe123 warned, "Sorry, if you put funds in GNMA's or short-term bonds, it is no longer cash. If (when?) we have a bond shock, there will be anguish over these strategies."

Weiwentg spoke from experience, "Before the crash, I got fancy and put some money into  Fidelity Ultra-Short Bond . My fellow readers can guess how well that turned out!" (The fund has taken on a much more conservative profile, but under a previous manager it lost 5% of its value in 2007 and another 8% in 2008.)

JohnCo summed up the case against chasing yield with your safe assets, writing, "I understand if people are unhappy not making anything on cash, but that dissatisfaction isn't a license to take risk with what is supposed to be your risk-free money. Being angry with the Federal Reserve, which is penalizing savers by lowering interest rates, is perfectly legitimate and understandable, but it's not a reason to endanger your safe money. Go work out to blow off some steam. Or maybe write your congressman. But don't endanger your safe money out of frustration.”

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