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Investing Specialists

Does Your Cash Alternative Pass Muster?

It's wise to get creative with part of your cash, but noncash alternatives might not offer liquidity and stability.

The topic of how to wring more income from your cash holdings is on your mind, based on the outpouring of responses to a query about this topic in Morningstar.com's Discuss forum. Many investors noted that they were sticking with true cash--miserly yields and all--and attempting to make the best of a bad situation by using high-yield savings accounts and laddering certificates of deposit, which often provide higher yields than products that offer daily access to your money.

Other posters noted that they were venturing out of cash altogether, instead embracing ultra-short-, short-, and intermediate-term bonds, as well as floating-rate, or bank-loan, funds. Oftentimes investors discussed using these higher-yielding noncash alternatives in addition to--rather than instead of--their cash.

The stable-value funds that are fixtures in many 401(k) plans also received repeat mentions as attractive alternatives to cash, and it's little wonder. While yields on these funds have dropped along with everything else during the past several years, the 2%-plus yield that one can earn on a stable-value vehicle beats most cash instruments by a good percentage point. To offer a more robust yield than cash, the funds invest in short- and intermediate-term bonds, then employ insurance wrappers to ensure a steady net asset value. Stable-value funds aren't risk-free, unlike FDIC-insured vehicles like CDs and bank-run money market accounts, but the funds have historically done a good job of holding principal levels steady.  

Other posters in the thread said that they're construing their safe investments even more broadly. For example, one investor quite rightly observed that deferring Social Security delivers one of the highest safe payouts around, albeit not right away. For every year you're willing to defer receipt of Social Security benefits from your full retirement age until age 70, you pick up an astounding 8% increase in your benefit. Better yet, those increases are guaranteed. Try matching that with your money market fund--or any bond fund, for that matter. 

In a related vein, I'd submit the idea of prepaying a mortgage in lieu of investing more in cash than you really need. Even if your mortgage rate is low, it's still likely to be double the rate you'd earn on CDs or money market funds, and the prepay is a guaranteed return on your money. The more you chip away at your mortgage now, the less you'll pay over the life of your loan.

A Three-Part Test
Yet it's also worth bearing in mind that such cash alternatives might not address all of the key tasks you might look for your cash to deliver: income (at least a little), stability, and liquidity. That an investment doesn't pass all three criteria may be OK with you, given where you are in your life and the other assets in your portfolio. But it's still worth making sure you're comfortable with the trade-offs, and that you're also setting aside true cash for near-term bills and emergency-fund purposes.

Take bond funds and floating-rate funds, for example. Even while their income potential is higher--in some cases significantly so--than what's available with cash holdings, their net asset values will fluctuate. Moreover, more equity-sensitive bond types like bank loans aren't likely to be a safe haven in a period of weak equity-market performance; they're likely to be dropping right along with your stock holdings. And while you can sell your bond fund whenever you like, provided it's an open-end bond fund or exchange-traded fund, you won't necessarily get what you paid for it. Thus, bond funds fail both the stability and liquidity tests. That might be acceptable, especially for those who have true cash set aside elsewhere, but it's a trade-off all the same.

Stable-value funds, while not technically cash, are a much more apt cash proxy. As noted above, the insurance wrappers backing these vehicles have helped the funds maintain a good record of keeping their net asset values stable, even during market shocks like 2008. Yet even though they have stability and income on their side, stable-value funds are found almost exclusively inside of 401(k) and other types of retirement plans. So if you're of pre-retirement age and one of your goals for your cash is to have ready access to it, stable-value funds fail the liquidity test. You'll pay a penalty on your withdrawal (as well as taxes, which are levied on all 401(k) withdrawals) if you're younger than age 55. That might be fine with you, particularly if you hold your emergency fund elsewhere and are looking to the stable-value fund as a fairly safe source of higher yield. But it's clear that stable-value offerings can't serve as your sole emergency fund if you're not yet retired.

The same is true of cash that might appear in your actively managed mutual fund holdings. While it might show up in your  Portfolio X-Ray and your manager may be able to deploy that money opportunistically in periods of market weakness, it's not yours to spend. Therefore, it's not an acceptable stand-in for money to meet immediate-term income needs or for an emergency fund.

Finally, alternative sources of safe income, such as deferring Social Security in order to pick up a higher rate of guaranteed income down the line, fail the "ready access to your cash" test. Ditto for prepaying the mortgage. A safe return on your money? Yes. Liquidity, no.

All of this is not to say noncash alternatives shouldn't have a role in your investment plan. Meager yields on cash all but demand that you don't stake more in the asset class than you absolutely need to, unless your aim is to take advantage of dropping security prices down the line, and that you consider your whole opportunity set when deciding where to deploy your money. But when it comes to liquidity and stability, cash will always be king.