Throughout 2001, the Federal Reserve has been cutting interest rates in an effort to stimulate the economy. Long-term, those cuts might pay off; short-term, though, the people who are paying are those who invest in low-risk cash equivalents. Since the beginning of the year, the average money market fund yield has fallen from around 6% to a measly 3.75%.
If you want higher yields without taking significant risks, consider ultra-short and short-term bond funds. These funds are not money market funds, which maintain a $1-per-share price. Instead, short and ultra-short funds will fluctuate slightly in price but those modest ups and downs may be a tolerable tradeoff for higher yields.
Ultra-short bond funds currently have average maturities of 2.4 years, according to Morningstar Inc., Chicago, and average yields of 6.6%. Short-term bond funds have average maturities of 3.4 years and average yields of 5.9%. (Short-term funds that hold only government bonds have slightly lower average yields of 5.5%.)
It may seem strange that ultra-short bond funds have such high yields. The reason? This category includes bank-loan funds, which take substantial risks. Lower-risk ultra-short bond funds invest in safer instruments and have yields that are slightly lower than the yields of short-term bond funds.
Low-risk short and ultra-short funds don’t have much volatility. For example, Strong Advantage Fund’s share price has fluctuated between $9.88 and $10.19 per share in the past 10 years; Vanguard Short-Term U.S. Treasury Fund, which holds only short-term obligations of the federal government has ranged between $10 and $10.37 since 1994. Like all Vanguard funds, this one has an extremely low expense ratio (0.27%), which is crucial in a bond fund. Because the interest comes from U.S. Treasury securities, it’s exempt from state and local income tax.
Short and ultra-short funds can be used as “parking lots” for money you eventually intend to invest. Suppose, for example, you receive an inheritance or a lump-sum distribution from a retirement plan. You want to invest that money in stocks but you’re reluctant to plunge in at what might prove to be a market top. Instead, you could park the money in a short-term bond fund and gradually move it into stocks
Insight: If you think you might need cash right away, stay with a money market fund. You shouldn’t risk losing principal just to increase your current yield. However, if you don’t expect to need cash for a year or more, you probably can increase your return by moving from a money market fund into a short or ultra-short fund.
