Thanks to the Federal Reserve’s campaign of rate increases, once-miserly yields on cash instruments have made a significant turnaround. certificates of deposit, money market funds, and other cashlike assets are finally generating attractive yields for the first time in decades.
Of course, it’s a mistake to overdo cash holdings, especially with inflation that has only somewhat cooled in recent months. Even with higher yields coming online, cash is still a losing proposition given that rising prices gobble up every bit of the purchasing power of your cash yields. But everyone needs an emergency cushion equal to three to six months’ worth of basic living expenses, at the low end. For retirees, I like the idea of maintaining a cushion of one to two years’ worth of portfolio withdrawals in liquid reserves; that way you don’t have to sweat losses in your stock and bond portfolios or risk having to sell them when they’re down.
The Best Short-Term Investments: What Matters Most?
As you sift among the various options for your short-term investments, keep three key items on your dashboard: yield, guarantees, and liquidity, and what matters the most given your situation. The short-term investments that promise the highest yields often come with at least some level of risk and/or constraints on your daily access to funds. It may be that you’re just looking for the highest safe yield and don’t care that much about liquidity. Or maybe having ready access to your funds—because you’re using the money as your emergency fund—is the name of the game.
Yield: While it's tempting to park your short-term investments in whatever is offering the highest yield right now, be sure to read the fine print. The accounts with the highest yields typically require you to maintain a minimum balance. Attractive "teaser" rates may also apply to the first few months you hold the account but drop after that. Additionally, that very high yield may only apply to balances under a certain level, often as low as $15,000, and you'll earn less if you hold more than that.
Liquidity: Liquidity constraints are another differentiator among cash holdings: If you're willing to tie up your money with a financial institution for a predetermined period of time—as is the case with certificates of deposit—you'll usually be able to earn a higher return than if you'd like to have ready access to your cash. Banks will pay you more for the certainty of knowing that your funds will be there for a specific period of time than they will if you could pull your cash at any time.
Guarantees: Also take a moment to think through whether you value an ironclad guarantee or are willing to go without in exchange for a potentially higher yield. Some cash instruments are fully FDIC-insured (up to the limits), while others are not. FDIC-insured accounts provide the assurance that you’ll be made whole if your account has a loss; FDIC insurance covers up to $250,000 per depositor per institution. On the shortlist of FDIC-insured investments are checking and savings accounts, CDs, money market accounts (not to be confused with money market mutual funds), and online savings accounts. Money market mutual funds aren’t FDIC-insured.
Surveying the Field of Short-Term Investments
Certificates of Deposit: CDs will typically offer the most compelling yields of all cash instruments, and they’re also FDIC-insured. Five-year CDs on Bankrate.com were recently yielding up to 4.5%, and two-year CDs were paying out 4.3% to 4.8% per year.
Yet there are a couple of caveats. One is that minimum deposits for the highest-yielding CDs might be $25,000 or even higher. More significantly, there’s a trade-off on the liquidity front: You’ll usually pay a penalty if you need to crack into your holdings before the maturity date. The longer the term of the CD, the bigger the penalty for cashing out early. For example, it’s common for five-year CDs to charge a penalty equal to six to 12 months’ worth of interest on early withdrawals, whereas one-year CDs might charge three to six months’ worth of interest. Banks offer so-called “no penalty CDs,” but yields are substantially lower.
Retirees or other individuals with ongoing cash flow needs can employ a laddered CD strategy, purchasing CDs of varying maturities; that way something is always maturing to meet cash flow needs. For emergency reserves, however, CDs will be less appropriate because withdrawals are apt to be unplanned and could trigger early-withdrawal penalties.
Online Savings Accounts: If you want daily liquidity, a decent yield, and FDIC protection, your best bet will tend to be a high-yield savings account through an online bank or a savings account through a credit union. The former offers FDIC protection, up to the limits, whereas credit union accounts are insured by another entity, the National Credit Union Administration. A recent scan of savings accounts on Bankrate.com uncovered savings-account yields of over 4%, and many of these accounts come with check-writing privileges. Minimum investment amounts also tend to be lower than is the case for CDs, but there may be requirements to maintain a minimum balance.
Money Market Mutual Funds: Money market mutual funds, offered by major investment providers like Fidelity, Schwab, and Vanguard, also offer daily liquidity and the convenience of having those funds live side by side with your long-term investments. But money market fund yields are still generally below those of online savings accounts today. Additionally, money market mutual funds aren’t FDIC-insured, though in practice most funds have done an excellent job of maintaining stable net asset values. (What’s confusing is that money market accounts are a type of savings account offered by banks; these accounts typically are FDIC-insured, though yields won’t usually be anything to write home about.)
Don’t confuse money market mutual funds with brokerage sweep accounts, though both are offered by investment providers. Interest rates on brokerage sweep accounts, which hold investors’ cash that hasn’t yet been invested, have ticked up a bit recently but are still well below other cash options, including money market mutual funds. For example, money market funds at Schwab were currently yielding as much as 5.05%, whereas the firm’s sweep account was paying out 0.45%. That argues against using a sweep account as the main receptacle for your cash.
Stable-Value Funds: Stable-value funds are another example of an investment that offers an often-decent yield in exchange for not checking the liquidity and guarantee boxes. Stable-value funds are only accessible inside of company retirement plans. They invest in bonds, so they’re not FDIC-insured; to protect investors’ principal, they employ insurance wrappers to help maintain a stable net asset value. Just bear in mind that stable-value funds carry drawbacks. Because you can only own such a fund within a 401(k), you’ll pay taxes and penalties to withdraw your money before retirement unless you meet certain criteria. In other words, don’t think of a stable-value fund as an emergency fund unless you’re already retired or close to it. Second, even though stable-value funds buy insurance wrappers to help protect investors’ principal, the assets aren’t guaranteed or eligible for FDIC protections.
Honorable Mention: I Bonds: In contrast with the preceding investment types, the income from which will be gobbled up by inflation, I Bonds are the only safe investment vehicle that will guarantee to make investors whole with respect to inflation. I Bonds are Treasury bonds that pay a fixed rate of interest as well as another layer of interest that varies with the current inflation rate, as measured by the Consumer Price Index. The inflation adjustment is made twice a year. I Bonds issued May 1, 2023, yielded 4.3%, comprising a fixed rate of 0.9% and an inflation adjustment of 3.4%.
As attractive as that is, however, it comes with a few asterisks. The first is that I Bonds fail the liquidity test. If you redeem an I Bond within five years of buying it, you'll forfeit three months' worth of interest. Purchase constraints are another drawback for large investors. New I Bond purchases are currently restricted to just $10,000 per year per Social Security number, with an additional $5,000 in I Bonds available for purchase through tax refunds.
A version of this article was published on Oct. 12, 2022.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.