June 2007
Better options
Our strategy involves two other short-term investments--short-term bond funds and bank-loan funds--that share some of the
characteristics of CDs and money-market funds but offer the potential for higher returns.
Short-term bonds, like CDs, can be used to lock in yields for longer periods of time when interest rates start falling. In addition, since the value of a bond increases when interest rates fall, the value of a fund that invests in bonds will rise under the same conditions. Short-term bond funds capture that increase in their share price. That means your total return--yield plus share appreciation--will usually exceed CD returns when rates are weakening. Also, there is no penalty for withdrawing money from a short-term bond fund whenever you want. That makes these funds almost as liquid as money funds.
When interest rates move up, money-market funds are a better choice than either CDs or short-term bond funds. Bond values and fund-share prices drop slightly when rates climb, restraining total return--yield minus share depreciation--when that happens.
The risk, however, is not great. Short-term bonds are less sensitive to price declines than other types of bonds, so it's rare for funds that invest in them to lose money. The last time it happened was back in 1994, when the Fed abruptly raised short-term rates and some funds lost as much as 1 percent for the year.
To do better than money-market funds when rates are rising, you'll have to turn to bank-loan funds, sometimes called floating-rate funds. These funds invest in pools of short-term corporate debt with generally higher rates than the investments that money-market fund managers are allowed to buy. At the end of March 2007, Morningstar reported that the average yield on the two dozen bank-loan mutual funds was 6.5 percent, compared with the average 4.6 percent money-market fund yield. And bank-loan funds are just as liquid as any other mutual fund.
Higher yields, of course, come with risk. Some floating-rate corporate debtors may default when the economy slows and their business sours. In the last recession, six of the bank-loan funds had at least one bad year where they lost more than 1 percent of their value. One, Morgan Stanley Prime Income, lost 5.9 percent in 2001, although that appears to be an isolated incident.
Short-term bonds, like CDs, can be used to lock in yields for longer periods of time when interest rates start falling. In addition, since the value of a bond increases when interest rates fall, the value of a fund that invests in bonds will rise under the same conditions. Short-term bond funds capture that increase in their share price. That means your total return--yield plus share appreciation--will usually exceed CD returns when rates are weakening. Also, there is no penalty for withdrawing money from a short-term bond fund whenever you want. That makes these funds almost as liquid as money funds.
When interest rates move up, money-market funds are a better choice than either CDs or short-term bond funds. Bond values and fund-share prices drop slightly when rates climb, restraining total return--yield minus share depreciation--when that happens.
The risk, however, is not great. Short-term bonds are less sensitive to price declines than other types of bonds, so it's rare for funds that invest in them to lose money. The last time it happened was back in 1994, when the Fed abruptly raised short-term rates and some funds lost as much as 1 percent for the year.
To do better than money-market funds when rates are rising, you'll have to turn to bank-loan funds, sometimes called floating-rate funds. These funds invest in pools of short-term corporate debt with generally higher rates than the investments that money-market fund managers are allowed to buy. At the end of March 2007, Morningstar reported that the average yield on the two dozen bank-loan mutual funds was 6.5 percent, compared with the average 4.6 percent money-market fund yield. And bank-loan funds are just as liquid as any other mutual fund.
Higher yields, of course, come with risk. Some floating-rate corporate debtors may default when the economy slows and their business sours. In the last recession, six of the bank-loan funds had at least one bad year where they lost more than 1 percent of their value. One, Morgan Stanley Prime Income, lost 5.9 percent in 2001, although that appears to be an isolated incident.
