When investing your hard-earned cash, there’s often a trade-off between returns and volatility. Low-volatility assets–like bonds and money market funds–offer modest returns compared to investments like stocks or crypto, which can experience significant fluctuations in price.
Both types of investments, however, have a place in a diversified portfolio. Since the Fed raised its benchmark rate significantly in the past year and a half, cash equivalents like certificates of deposit (CDs) and fixed-income investments like bonds offer higher interest rates, making them more appealing to investors.
These investments offer different amounts of liquidity–some require you to lock up your money for long periods, while others don’t. While these investments are lucrative right now, there are upsides and downsides to stashing your cash in them.
High-yield savings accounts
High-yield savings accounts are deposit accounts that offer higher annual percentage yields (APY) than traditional savings accounts. These accounts are considered risk-free–but only if you opt for an FDIC or NCUA-insured bank or credit union and keep your balance below the $250,000 per depositor per bank threshold.
APYs on high-yield savings accounts fluctuate with the Fed’s benchmark rate–when the Fed increases that rate, APYs typically rise, and vice versa.
Hint: online banks usually provide higher rates than brick-and-mortar banks.
Some banks may limit you to six monthly withdrawals when you want to access your cash. During the pandemic, however, the Federal Reserve waived the six withdrawal per month regulation, so you can tap your money as needed.
And don’t be surprised when you receive tax forms from your bank regarding your deposit accounts: Interest earned on deposit accounts is taxable, so you’ll have to pay income tax on your earnings.
Certificates of deposit (CDs) and share certificates
Like high-yield savings accounts, CDs or share certificates are a type of deposit account offered by banks and credit unions, which are covered by FDIC or NCUA insurance.
These accounts typically offer higher APYs than high-yield savings accounts because they require you to commit a fixed amount of money for a fixed term. Terms can range from a few months to many years.
If you tap your money early, you’ll generally pay an early withdrawal penalty worth a few months of interest or more–be sure to do your research, as longer-term CDs may have higher penalties.
While CDs are low-risk investments, they are subject to reinvestment risk, or the risk you have to reinvest your money at a lower interest rate after your CD reaches maturity.
“We’re seeing attractive yields on three, six, 12 month CDs, but the risk is that in six or 12 months when you have to reinvest those maturing proceeds if the Fed has cut rates, you might be reinvesting at a lower yield,” says Collin Martin, director, fixed income strategist at Schwab.
To minimize this risk, consider creating a CD ladder, an investment strategy where you purchase CDs with staggering maturities. This strategy allows you to take advantage of higher rates offered on longer-term CDs while giving you access to cash at regular intervals.
Learn more about CDs:
- Best 6-month CD rates
- Best 1-year CD rates
- Best 3-year CD rates
- Best 5-year CD rates
Money market accounts
Money market accounts are similar to checking and savings accounts–they typically provide higher APYs than checking accounts and easier access to cash than savings accounts. And since they’re considered deposit accounts, they’re covered by FDIC or NCUA insurance.
Like savings accounts, APYs on money market accounts are variable, typically changing with the federal funds rate. You may have to maintain a minimum balance to reap the benefits of a money market account. Otherwise, you may have to pay a monthly maintenance fee.
Some money market accounts also have check-writing privileges and a debit card connected to the account, so it’s an excellent spot to park short-term savings.
Treasury securities are debt obligations issued by the U.S. government, so they’re a (mostly) risk-free investment.
When you purchase a Treasury, you lend money to the government, which it then uses to finance its expenses. You tie up your money for a fixed period, and the government gives you semiannual interest payments plus the principal (or the amount you initially invested) when the bond matures.
There are many types of Treasurys–with terms ranging from four weeks if you purchase a Treasury Bill to 30 years if you opt for a Treasury Bond. While you can sell Treasurys before they mature, they are susceptible to interest rate risk, which means their price fluctuates with interest rate changes.
You can think of interest rate risk like this: You buy a bond with a 3% interest rate, and the following year, the market rate on bonds has increased to 5%. When you try to sell your 3% bond, investors prefer the 5% one. The price of your 3% bond falls because it’s less lucrative than the 5% bond, and you lose money when you sell it.
You can benefit from purchasing Treasurys as they offer unique tax benefits: Treasurys are exempt from state and local taxes, though they are subject to federal tax.
Series I bonds
Unlike Treasurys, Series I bonds offer monthly interest payments and an interest rate that changes with inflation. It’s a solid investment option when prices are high, but a not-so-solid choice when inflation falls and rates are lackluster.
The interest rate on I bonds is a combination of a fixed rate and an inflation rate that’s set every six months.
Series I bonds have a duration of 30 years, but you can cash it before if you’ve held it for at least a year. Doing so, however, could mean losing out on interest payments. If you cash in the bond before five years is up, you’ll miss out on three months of interest.
Since the Treasury issues them, they’re risk-free investments, and you receive tax benefits–you’ll have to pay federal taxes on them, but they’re exempt from state and local taxes.
Municipal bonds, or munis, are issued by state, city, and local governments. When you invest in munis your money is used to fund projects such as highways or schools. Like Treasury Bonds, the duration of munis varies from a year to more than a decade.
One of the major benefits of investing in municipal bonds is that they’re exempt from federal taxes. Depending on if you live in the state they’re issued, munis may also be exempt from state and local taxes. Because of their tax benefits, munis typically offer lower interest rates than other types of bonds, like corporate bonds.
One of the downsides of investing in munis is that they’re subject to liquidity risk, which is when it’s difficult to sell or trade a security. It may be challenging to sell munis because the market to sell them is usually small, so they’re not a great investment option if you need access to your cash fast.
Like all bonds, munis are also subject to interest rate risk.
Companies issue corporate bonds to raise capital. Like other bonds, investors receive regular interest payments and the principal once the bond matures.
These bonds are riskier than those issued by the federal government because the U.S. government is unlikely to default. Some agencies, like Moody’s, are responsible for rating bonds based on their risk level–with riskier bonds commanding higher yields.
Since corporate bonds are rated based on a company’s ability to pay, they’re subject to default risk, which is the risk that a company will default or fail to make its interest or principal payments.
Corporate bonds are susceptible to liquidity and interest risk like other fixed-income securities. Their price may fluctuate with changes in the interest rate, and they can be challenging to trade and sell.
Money market funds
Money market funds are low-risk mutual funds invested in safe short-term assets like Treasury securities, CDs, and municipal bonds. Since these funds are invested in short-term assets, they tend to follow short-term interest rates, fluctuating with changes to the Fed’s benchmark rate.
Unlike money market accounts, money market funds are not FDIC-insured–though they’re considered relatively safe, and you’re unlikely to lose money by investing in them.
You can invest in a money market fund through a brokerage account, and your money will be easily accessible, making it a solid place to park money for a down payment or an emergency fund.
If you invest in a dividend stock, you’re getting a piece of equity in a company and profits in the form of dividends. Dividends are earnings companies pay to shareholders quarterly, semi-annually, or annually.
Generally, more well-established companies, known as value companies, pay out dividends because they don’t need to reinvest their money to grow, according to Scott Sturgeon, CFP and founder of Oread Wealth Partners.
“As an incentive to shareholders, [value companies] issue dividends, or periodic payments to the shareholder. These are similar to interest [payments] on a bond,” says Sturgeon. “Because these companies have been around for a long time or have name recognition, they could be viewed as a little more conservative.”
However, unlike interest payments you receive when you purchase a Treasury security, dividends are not guaranteed. During financial turmoil, companies may reduce or slash their dividend payments entirely.
Rather than investing in individual company’s dividend stocks, you may want to minimize risk by investing in exchange-traded funds (ETFs) or mutual funds that pay dividends. This way, you’re spreading your risk by investing in many companies simultaneously.
When it comes to paying taxes, dividends are either taxed at your ordinary income tax rate or the capital gains rate.
Some cash equivalents–like money market accounts–and fixed-income securities are offering stellar returns because of the Fed’s rate hikes. While these investments may provide generous yields, those yields may vary with changes in the Fed’s benchmark rate, making many of these investments susceptible to reinvestment risk.
“We’re trying to get [clients] to not just be sitting in cash right now. We know it’s attractive, but when you think of it from a long-term standpoint, we’re encouraging them to think about alternatives, so they’re not so dependent on what the Fed does or doesn’t do over the next few years,” says Martin.
Fixed income and cash can help minimize volatility and preserve capital in your investment portfolio, but pouring all your money into them could undermine your long-term financial goals. Instead of chasing high yields, you should focus on creating a portfolio–composed of stocks, bonds, and cash–that aligns with your liquidity needs, risk tolerance, and investment horizon.
As a seasoned financial expert with a deep understanding of investment strategies and financial markets, I can provide valuable insights into the concepts covered in the article. With a background in finance and investment analysis, I've had extensive experience navigating various investment instruments and have a comprehensive understanding of the factors influencing market dynamics.
The article discusses a range of investment options, each with its own set of characteristics, risks, and potential returns. Let's break down the key concepts covered in the article:
Volatility and Returns Trade-off:
- The article begins by highlighting the common trade-off between returns and volatility when investing. Low-volatility assets like bonds and money market funds offer more stable returns compared to higher-risk investments like stocks or crypto.
Impact of Fed's Benchmark Rate:
- It emphasizes the influence of the Federal Reserve's benchmark rate on different investment types. For instance, the article notes that the Fed's rate hikes have led to higher interest rates on cash equivalents like certificates of deposit (CDs) and fixed-income investments like bonds.
- The article stresses the importance of a diversified portfolio, where both low-volatility and higher-risk investments have a place. Diversification helps manage risk and optimize returns.
High-Yield Savings Accounts:
- Discusses high-yield savings accounts as risk-free deposit accounts offering higher annual percentage yields (APY) than traditional savings accounts. Emphasizes the role of FDIC or NCUA insurance in ensuring safety.
Certificates of Deposit (CDs) and CD Ladder Strategy:
- Highlights CDs and share certificates as low-risk, fixed-term deposit accounts. Introduces the CD ladder strategy to mitigate reinvestment risk by staggering maturities.
Money Market Accounts:
- Describes money market accounts as deposit accounts with higher APYs than checking accounts. Emphasizes their variable APYs and the need to maintain a minimum balance.
- Explores Treasury securities as low-risk, government-issued debt obligations. Discusses interest rate risk and tax benefits, such as exemption from state and local taxes.
Series I Bonds:
- Compares Series I bonds to Treasurys, highlighting their monthly interest payments and inflation-adjusted interest rates. Discusses the 30-year duration and potential tax benefits.
- Introduces municipal bonds issued by state and local governments, emphasizing their tax benefits. Discusses liquidity risk and interest rate risk associated with munis.
- Covers corporate bonds issued by companies to raise capital. Discusses default risk, liquidity risk, and interest rate risk associated with corporate bonds.
Money Market Funds:
- Describes money market funds as low-risk mutual funds invested in short-term assets. Differentiates them from money market accounts and mentions their sensitivity to short-term interest rates.
- Explains dividend stocks as equity investments that pay periodic dividends. Emphasizes the role of ETFs or mutual funds to spread risk. Discusses the uncertainty of dividend payments during financial turmoil.
Investment Portfolio Strategy:
- Encourages investors to focus on creating a well-balanced portfolio comprising stocks, bonds, and cash. Advises against overreliance on cash equivalents due to potential long-term implications.
In conclusion, the article provides a comprehensive overview of various investment options, shedding light on their characteristics, risks, and considerations. Investors should carefully evaluate their financial goals, risk tolerance, and time horizon when making investment decisions.