Safe Investments
Summary
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For the maximum yield consistent with maximum safety from credit risk and interest rate risk, buy Treasury Bills with the shortest available maturities through Treasury Direct. This requires keeping track of maturity dates. I don't recommend this unless you have a VERY large portfolio (millions of dollars).
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If rolling over Treasury Bills is too inconvenient to make it worth your while, use Vanguard Treasury money market funds. For cash balances of at least $50,000, use Vanguard's Admiral Treasury Money Market Fund, which has a rock-bottom expense ratio (around .15%) and thus the highest yield among Treasury money market funds. For cash balances under $50,000, use Vanguard's Treasury Money Market Fund. Using a Vanguard Treasury money market fund gives you the safety of US Treasury Bills, a yield close to that of US Treasury Bills, and the convenience and liquidity of bank accounts.
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Be aware that Federal money market funds invest in US government agency debt, such as that from Fannie Mae and Freddie Mac. Unlike Treasury Bills, Notes, and Bonds, this debt is NOT backed by the full faith and credit of the US Treasury. This could be an issue if Fannie Mae and Freddie Mac get stuck with bad loans and the US Treasury refuses to bail them out. Given the situation involving the credit and housing bubble, I don't think the tiny bit of extra yield is worth the risk.
Money Market Mutual Funds
What They Are
Money market funds (MMFs) give you the highest returns consistent with safety and liquidity. MMFs are mutual funds that invest in money market securities and attempt to (usually successfully) maintain a $1/share net asset value. In other words, they pool the money of investors to buy money market securities (short-term loans to the highest-quality borrowers), such as Treasury bills, U.S. government agency securities, commercial paper, and bank CDs.
Liquidity
Money market funds are very liquid; there generally are NO loads, commissions, early withdrawal penalties, fees, or other charges to enter or exit one. In fact, most money market funds offer free checkwriting privileges.
Safety
All money market funds are prohibited by the SEC from investing in issuers with weak credit ratings, extending average portfolio maturites beyond 90 days, or concentrating their portfolios in any one company or industry.
How to Select a Money Market Fund
You should look for:
Low Expense Ratios
The money market fund management charges management fees through automatic deductions from interest payments. Management fees are a percentage of fund assets called the expense ratio. The lower the expense ratio, the better. There is little variation in yields from one money market security to another. As a result, expense ratios are by far the largest factor affecting money market fund yields.
Low Expense Ratios that Last
Sometimes, expense ratios are temporarily reduced to increase the yield and attract shareholders. Unfortunately, the yield declines when the normal fees are reinstated. Furthermore, the fund companies end the free ride abruptly, and even if you knew when to switch funds, fund surfing would be big hassle for a fraction of a percentage point in yield. Thus, look for a MMF that keeps its expense ratios low for the long-haul and be suspicious of any MMF that temporarily waives the management fee.
Safety
Unfortunately, the safety of some money market funds has been compromised. A few money market funds have had their net asset values fall below $1.00/share due to defaulting securities. Fortunately, there are precautions you can take.
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AVOID MMFs that invest in derivatives or other exotic securities. MMFs were intended to stick with Treasury Bills, US Government Agency securities, high-quality commercial paper, and high-quality state and municipal paper. Unfortunately, many MMFs have invested in repurchase agreements, reverse repurchase agreements, Eurodollars, Yankeedollars, and other exotic things. You should AVOID MMFs that invest a large percentage of assets in these riskier assets. Although most of even these exotic securities avoid snafus and MMF managements can bail out shareholders, it is difficult for you to assess the securities, and the tiny bit of extra yield is not worth sacrificing your peace of mind. The Orange County bankruptcy is a classic example of this. The treasurer invested the county government's money in derivatives that failed. This caused Orange County to default on securities, and this default affected several money market funds.
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AVOID MMFs that have higher yields than you would expect after considering expense ratios, credit quality, and average portfolio maturity. This is a sure sign that there are derivatives in the portfolio.
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If you are concerned about the possibility of investment grade securities defaulting (like Penn Central, Orange County, or the WHOOPS fiasco), use a money market fund that only invests in federal government securities.
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Select a fund company with deep pockets. A few money market funds have had to bail out shareholders due to derivatives or defaults. Make sure your fund has the resources to do this.
Tax Benefits
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If you are in a high nonfederal (state+local) income tax bracket, use a money market fund that only invests in US Treasury securities. US Treasury securities are EXEMPT from state and local income taxes and are only subject to federal income taxes.
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If you are in a sufficiently high federal income tax bracket, you may earn more interest after-tax in a municipal money market fund. HOWEVER, you should be aware of the risks. Single-state money market funds are restricted to investing in one particular state and thus lack the diversification that more general money market funds have. Local problems can compromise the safety of the state and municipal securities and, by extension, the safety of a portfolio heavily invested in these securities.
Why Vanguard Is Best
In the course of your research on money market funds, you will quickly see that Vanguard is superior to all other mutual fund companies.
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Vanguard is well known for maintaining expense ratios that are by far the lowest in the industry and less than half the industry average.
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As a result of the low expense ratios, Vanguard MMF yields crush most of the competition in the short term and all of the competition in the long term.
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Vanguard MMFs offer FREE checking privileges. The minimum check size is $250, but you can use your checking account for writing smaller checks.
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Vanguard is well known for its prudent money management philosophy.
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The money market Treasury portfolios contain NO derivatives and only US Treasury securities.
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Vanguard is one of the largest mutual fund companies. In the unlikely event of a money market snafu, it would have the resources necessary to bail out shareholders.
Which Vanguard Money Market Funds To Use
Vanguard has 5 money market funds: Prime, Prime Institutional, Federal, Treasury Admiral, and Treasury.
Federal
The Federal portfolio would be best for most people due to its safety and high yield.
Treasury Admiral
This fund is best for those who at least $50,000 in cash and either a high state+local income tax bracket or a fear of a financial armageddon that affects everything but U.S. Treasury securities. Because the Treasury Admiral fund is restricted to large accounts and large accounts have lower administrative costs relative to the assets, this fund has even LOWER expense ratios than other Vanguard funds.
Treasury
This fund is for those who want to be in the Treasury Admiral portfolio but do not have $50,000 cash.
Federal
Be aware that Federal money market funds invest in US government agency debt, such as that from Fannie Mae and Freddie Mac. Unlike Treasury Bills, Notes, and Bonds, this debt is NOT backed by the full faith and credit of the US Treasury. This could be an issue if Fannie Mae and Freddie Mac get stuck with bad loans and the US Treasury refuses to bail them out. Given the situation involving the credit and housing bubble, I don't think the tiny bit of extra yield is worth the risk.
Prime
It is probably safe, but it usually yields less than .1 of a percentage point more than Federal, and a large part of the portfolio consists of derivatives like Eurodollars, Yankee dollars, repurchase agreements, and other complex securities. If you understand these derivatives, this may be the best choice for you. Although Vanguard is well known for its prudence, I'm willing to sacrifice a tiny bit of yield in favor of the Federal money market fund.
Prime Institutional
If you understand the above derivatives well enough to use the Prime portfolio AND have at least $50,000, then this is the fund for you.
Banks: Hazardous to Your Wealth
If you are laughing all the way to the bank, then the joke is on you! The bank is the WRONG place for your savings to due to uncompetitive returns, fees, potential risks, and other restrictive and costly terms for customers. If you want to keep your money safe, use a money market fund.
FDIC Insurance
Although you should only do business with a bank that has FDIC insurance, be aware of its limitations. First, the FDIC guarantees the principal but NOT the interest. Second, only the first $100,000 of your money (if you have that much) is insured. Finally, if you have to use FDIC insurance, your money will be FROZEN for weeks or months and earn NO interest. I consider US Treasury Bills and Vanguard Treasury money market funds to be safer than FDIC-insured bank accounts. Remember that the US Treasury has the authority to print money to pay you off while the FDIC does not.
Checking Accounts
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Checking accounts should only be used for everyday convenience, NOT as savings vehicles. Look for a low minimum balance (about $100 or less), an absence of unavoidable monthly fees, and no pesky rip-off fees (like teller fees, per-check fees).
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Don't bother with interest-bearing checking accounts, because they nearly always have VERY low yields and VERY high minimum balance requirements.
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Make sure that the bank's finances are safe; even if FDIC insurance (which you should insist on) will bail you out, it will take you weeks or months to collect, during which time your money is frozen and earns no interest.
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Most importantly of all, AVOID keeping any more money (a few hundred dollars) in your account than needed for everyday bills and withdrawals. Remember that most money market funds allow you to write as many large checks (at Vanguard, $250 or more) as you wish to ABSOLUTELY FREE.
Savings Accounts: NOT for savings
Do NOT be misled; savings accounts are actually bad for your savings. Why can't savings accounts be good dinosaurs and die? Savings accounts deserve to be as obsolete as the Berlin Wall. The yields, though slightly better than those of interest-bearing checking accounts, are STILL pathetic. Furthermore, savings accounts offer no checking privileges and limit the number of withdrawals you may make. Money market funds (especially Vanguard) yield MUCH more, and most money market funds (including Vanguard) allow you to write as many checks as you wish. Some money market funds allow you to open an account for as little as a few hundred dollars, and Vanguard has no minimum balance for those who invest through its customer-friendly brokerage service. The savings account deserves to die, but it keeps going and going and going . . . .
Money Market Deposit Accounts
MMDAs are bank products that were created in the 1970s and 1980s in response to the rise of the MMF industry. I consider MMDAs money market fund IMPOSTERS that should have gone the way of the 8-track. Although the MMDAs yield slightly more than savings accounts, they STILL fail to compete with MMFs. Furthermore, MMDAs usually have MUCH stricter rules. They have minimum balance requirements of thousands od dollars, allow you to write only a few checks per month (even as most MMFs, including the Vanguard funds, have no such limit), and are riddled with fees and restrictions that are almost unheard of in the money market fund industry (especially at Vanguard). The bank money market fund is the saver's 8-track.
Certificates of Deposit
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Although CDs with short maturities yield somewhat more than MMDAs, they STILL fail to compete with MMFs. Average MMF yields are consistently higher than average short-term CD yields. Few short-term CDs outyield Vanguard MMFs.
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Most CDs with longer maturities yield less than comparable alternatives like Vanguard bond funds, Treasury Notes, Treasury Bonds, and brokered CDs.
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Furthermore, the CD carries credit risk, as the bank could fail, and the FDIC insurance suffers from the limitations I described earlier.
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The main rip-off, however, is the illiquidity. If you want access to your money before maturity, the bank charges you an early withdrawal penalty. Furthermore, CDs AUTOMATICALLY roll over at maturity; this automatic renewal is bad for busy or forgetful people. Due to this illiquidity, I call CDs Certificates of Confiscation.
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Furthermore, the CDs with longer maturities carry the special risks of bonds (which I will describe later).
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Dumb Excuses For Not Using A Money Market Fund
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The yield difference isn't that signficant. NOT! If you believe this one, I'll be more than happy to borrow money from you at an interest rate much below those prevailing in the marketplace.
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Banks are safer than money market funds. NOT! During the S&L crisis of 1990, hundreds of banks failed. Money market funds, on the other hand, have had a much better track record. No individual investor has ever lost money in a money market fund.
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But several money market funds have "broken the buck". Even so, the money market fund industry still has a MUCH better safety record than the banking industry. Most funds that have "broken the buck" were bailed out by the parent companies. Only one fund, a small fund for institutions, allowed shareholders to lose principal, and this loss was only 4 cents on the dollar. There are several money market fund risk factors that I will describe later; avoiding funds that contain these risk factors will reinforce your safety by many orders of magnitude.
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Banks have FDIC insurance but money market funds do not. As I explained earlier, FDIC insurance has several severe limitations. In my opinion, it would be better to do business with a sounder institution. And as I explained before, the money market fund industry, despite a few bad incidents and a lack of FDIC insuranace, has a MUCH better safety record than the banking industry.
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Money market funds are inconvenient. NOT! A money market fund does not replace the convenience of a checking account at a bank, BUT money market funds never were intended for everyday withdrawals from a teller, frequent checking transactions, or third-party deposits. However, you can make money market fund transactions by mail using postage-paid envelopes or by telephone with toll-free telephone numbers. To deposit money in a money market fund, use direct deposit (if available) or send a check against your bank account to the money market fund. To withdraw money from your money market fund, simply write a check against the money market fund and deposit it in your bank account. If your bank is part of the Automated Clearinghouse network, you may be able to move money between your bank account and money market fund with a telephone call.
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What about fees? Unlike some bank accounts, most money market funds (including Vanguard funds) allow you to write as many large checks as you want for free. Unlike CDs, money market funds have NO early-withdrawal penalties.
Bonds: Hazardous to Your Wealth
Bonds are considered safe investments and a staple for retirees. I strongly disagree. I see bonds (INCLUDING U.S. Treasury Bonds) as a risky bet on interest rates. The term "fixed income" creates a false sense of security. Although the income you receive is fixed, the inflation rate and the market interest rates are NOT fixed, and this has ramifications on your bond investment.
Bad Scenario: Rising Interest Rates
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If interest rates rise after you buy the bond, you will find that the yield you are earning is below what the market is currently paying. You have the option of holding the bond until maturity, but your return is less than what it would have been had you stuck with money market investments. The longer the duration of the bond, the greater this opportunity cost.
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Your other option is to sell the bond. Unfortunately, rising interest rates cause bond prices to fall, and you will suffer a capital loss. At the height of the Volcker credit squeeze in 1981, some long-term Treasury bonds sold for barely 50 cents on the dollar.
Bad Scenario: Rising Inflation
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Inflation erodes the purchasing power of your bond and the interest payments you will receive. Unfortunately, the inflation rate may rise. If this happens, the interest payments won't be sufficient to cover this increased erosion of your purchasing power.
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To add insult to injury, rising inflation usually triggers rising interest rates.
Good Scenario: Falling Interest Rates
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If you hold the security, you earn an above-market yield. But earning a few percentage points above market yields is NOT a sufficient reward for the risk you take. Stocks USUALLY give you a much greater profit potential if everything goes right for you.
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If you sell the security, you can sell at a capital gain. But again, stocks USUALLY have much more profit potential. Don't expect to strike the jackpot.
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MOST important: Interest rates are IMPOSSIBLE to predict reliably.
Good Scenario: Falling Inflation
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If inflation declines or gives way to deflation, the interest income generously compensates you for the slower rate at which your purchasing power erodes. Furthermore, falling interest rates usually accompany such a scenario.
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Again, your return is limited, and inflation is IMPOSSIBLE to predict reliably.
Credit Quality
Unless the bond issuer has the authority to print money, there is a chance that it won't pay you back. Thus, credit quality is an issue for all bonds except for those issued by the US Treasury.
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The companies that issue bond ratings are sometimes wrong, and even investment grade bonds CAN default (as proven by Penn Central, WHOOPS, and Orange County).
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Credit quality can decline. When this happens (due to increasingly adverse business conditions), the yields on your bonds must rise in order to fairly compensate prospective new bond buyers. Unfortunately, this means that the value of your bond declines, and to add insult to injury, the risk of default is greater.
VERY Bad Scenario: Prepayment Provisions
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If the security can be called, prepaid, or retired before maturity, the issuer pays you off early WITHOUT providing you the full capital gain you are entitled to. This is a classic case of "Heads - I win, tails - you lose". Thus, avoid bonds with any such provisions.
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Also, avoid mortgage-backed securities, since falling interest rates induce homeowners to refinance their mortgages.
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You may be able to profit if interest rates remain the same, and the security has a higher yield than others of comparable maturities and credit quality. However, the premium is quite modest while the likelihood of fluctuations (up OR down) in interest rates over a period of several years is nearly certain.
Choices For Those Who Insist on Buying Bonds Anyway
I assume that you are aware of interest rate risk and believe that interest rates will not rise above current levels over the coming years. As I mentioned earlier, AVOID bank CDs due to their illiquidity. In fact, even if interest rates fall after you buy a bank CD, the early withdrawal penalty STILL applies while the capital gain you should be entitled to does NOT.
Treasury Notes/Bonds
Treasury Notes and Bonds are issued by the United States Treasury and are thus of the very highest credit quality. Treasury Notes have maturities of 1 to 10 years, while Treasury Bonds have maturities of 10 to 30 years. Although you must pay a broker a commission in order to sell a Treasury Note or Bond, you are NOT subject to the early withdrawal penalty that a bank CD would inflict on you.
Bond Funds
Vanguard Bond Funds
As was the case for money market funds, the low expense ratios and prudent management make Vanguard bond funds superior to other bond funds.
Brokered CDs
Brokered CDs are CDs sold indirectly through stockbrokers. Although you must pay the broker a commission in order to sell, you are NOT subject to the early withdrawal penalty. Additionally, brokered CDs yield more than CDs bought directly from a bank.