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Where to stash cash
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October 19, 2001: 10:28 a.m. ET
Even steering clear of the stock market requires a good strategy.
By Laura Lallos
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NEW YORK (Money) - Security. That's what we crave right now. Investors were tentative about the stock market even before Sept. 11, after a year-long slowdown that was congealing into a recession. According to the Investment Company Institute, during the first eight months of this year, nearly five times as much money flowed into money-market funds as went to stock funds.
Problem is, dealing with this uncertain market is more than a matter of diversifying into cash and bonds. You need to make sure that your cash and bond holdings are themselves properly apportioned to balance income, safety of principal and interest-rate risk.
We've divided your options into four categories, each focused on a different strategic need: what to do with short-term cash reserves; what to do with cash that you hold as a portfolio cushion; how to take advantage of the bond market to maximize total return; and when to tap municipal bonds for extra income.
Cash on hand
Beyond money to cover month-to-month living expenses, your short-term cash shouldn't languish in passbook savings or even in bank money-market accounts, which currently pay well under 3 percent. Look to money-market mutual funds that offer check-writing privileges and, typically, higher yields.
But even money-market funds offer slim pickings these days, paying out roughly 2.5 percent, compared with 5 percent just six months ago. Average rates will continue to drop, because money-market funds will have to reinvest in today's lower-yielding notes as their older holdings mature.
Vanguard Prime Money Market Fund currently yields a little less than 3 percent, thanks to its older issues. "But if we had to reinvest it all in September," notes Vanguard bond expert Ken Volpert, "the yield would be more like 2.25 percent."
How to eke out extra yield? Stick to fund companies that you can count on to keep costs low, like Vanguard, Fidelity and TIAA-CREF. Their money-market funds will consistently pay above-average yields.
If your cash savings are primarily for peace of mind, and you're unlikely to dip in for a couple of years, consider a short-term bond fund (with maturities ranging from two to five years). Yields are thin here too, so low expenses remain essential. Look for a fund that offers exposure to a variety of short-term bonds, not just short-term Treasuries, which are now yielding well under 3 percent.
Vanguard Short-Term Bond Index covers all the bases -- Treasuries, corporate bonds and mortgages -- and charges only 0.21 percent in expenses (vs. 0.86 percent for the average short-term bond fund). Strong Short-Term Bond Fund takes some extra credit risk to boost its return. Keep in mind, however, that you could actually lose money should interest rates turn around. When rates bumped up during 1994, the typical short-term bond fund lost 0.7 percent for the year, and a handful shed more than 3 percent.
Cash as a cushion
If you want cash for long-term stability in your portfolio and know for sure that you won't touch it, you might be tempted to sock it away in a certificate of deposit. After all, you could still lock in more than 4 percent in late September if you were willing to stow your money for three years. Comparison shop nationwide at bankrate.com. (Before you commit, make sure the CD isn't "callable," a term that means the bank can redeem your CD ahead of schedule if rates fall.)
But if interest rates do tick up in a year, you may regret having your cash tied up at today's low, low rates. I Bonds, or inflation-adjusted 30-year savings bonds, are an attractive way to diversify long-term cash. (You must hold them for at least six months, and you'll get docked three months' interest if you sell before five years.) I Bonds come with a 3 percent fixed rate, plus a fluctuating inflation adjustment that currently brings the total payout to a not shabby 5.92 percent. If inflation increases, so will your composite rate.
Interested? Act quickly: The fixed rate is set May 1 and Nov. 1, and will likely be lower come November. You can buy I Bonds online at savingsbonds.com.
If you can tolerate some price fluctuation, you might opt for Treasury Inflation-Protected Securities, or TIPS -- available online at Treasurydirect.gov. Another option: Vanguard Inflation-Protected Securities Fund. Just be sure to shelter these in an IRA -- unlike I Bonds, which are tax deferred until redeemed, TIPS' inflation adjustments are taxed yearly.
Bonds for total return
Hoping bonds will boost your portfolio returns as stocks stagnate? You're too late for Treasuries. Economic and political turmoil typically spur a flight to quality, and investors have already pushed prices up and yields down.
The bond managers we admire all agree that corporate bonds offer the best opportunities right now. John Bender, who co-manages Strong's top-notch Short-Term and Corporate Bond funds, points out that corporate yields are dramatically better than Treasuries'. "Five-year, AA-rated Citigroup bonds currently yield more than 5 percent, 1.2 percentage points more than a five-year Treasury," he notes. "That's 30 percent more income just for betting that the country's largest bank won't default."
Vanguard's Volpert recommends sticking with bonds rated no lower than AA if you're buying on your own (for more on how to do that, see "On the Bond Wagon"). (AAA bonds have the least credit risk; single-A bonds have more. If you venture below BBB, you've entered the junk market.)
But a diversified bond fund has more leeway -- and you need much less money to get started. Strong Corporate Bond is a good choice, as is Harbor Bond Fund, run by the best bond investor in the country, Pimco's Bill Gross.
If you want to get aggressive, high-yield bonds may be even better bargains. But if the economy doesn't pick up next year, high-yield bonds could indeed be junk. Play this area safely with a diversified fund that merely dips into high yields, like Bob Rodriguez's FPA New Income. If you're hell-bent on a pure high-yield play, put a portion of your bond stake in Pimco High Yield or Northeast Investors Trust, which take a relatively moderate approach.
Overwhelmed by the possible scenarios? Stick with Vanguard Total Bond Market Index for the long run. It's been one of the top performers among diversified funds for years.
Munis for income
Maybe this year's tax cuts have made tax-free municipals seem less relevant. But insured AAA munis are now the best way to maximize both credit safety and current income in your taxable portfolio. The higher your tax bracket and state income tax rate are, the truer this is.
On Sept. 28, for example, the typical 10-year, top-quality, AAA-rated insured muni was yielding 4.3 percent. That's the equivalent of at least 7.06 percent -- depending on your state -- on a taxable bond for an investor in the 39.1 percent bracket (the new top tier for 2001). Compare that with 10-year Treasuries, which were yielding 4.59 percent that day.
The spreads between yields on munis and Treasuries are so wide now that even investors in lower tax brackets and low-tax states should consider munis. The tax cuts enacted by Congress this year don't diminish munis' attractiveness. An investor in the still hypothetical 35 percent top tax bracket (scheduled to take effect in 2006) would enjoy a tax-equivalent yield of at least 6.62 percent on today's 10-year AAA muni.
If you don't want to buy munis yourself, Vanguard Intermediate-Term Tax-Exempt is the fund to beat; the firm also offers special funds for high-tax states like California and New York. USAA Tax-Exempt Intermediate-Term digs into riskier bonds for higher yields but doesn't go crazy. 
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OTHER SAFE HAVENS
