Right On Cue!

It must be something in the water. Or a conspiracy! The same week Bloomberg posts a nice article about the dangers of high yield, Fidelity chimes in with a look at how investors can earn more interest "without excessive risk". Let's see what they have to say. The story is here.

With the average checking account and three-month brokered certificate of deposit (CD) yielding a humble 0.25%,1 you may be yearning for a little more yield on your everyday cash and short-term investments.

Well, don't expect much help from the Federal Reserve, which continues to indicate that it plans to hold its benchmark Federal Funds rate low for an extended period. Still, there are ways that could help you eke out more yield on your cash and short-term investments—without taking on excessive risk.

"It can be done without committing either to long-term bonds or to the volatility that can come from dipping too far down in credit quality," says Richard Carter, vice president of fixed-income securities at Fidelity. "The recent steepness of the Treasury yield curve (see chart below) means that you may be able to get a little more yield for extending maturities a little further than you would have in a period like year-end 2006, when the curve was essentially flat."

What You Can Do

First determine how much of your short-term investments are for immediate needs and has to be easily accessible and liquid. This money should stay in a checking account, money market account or fund, or short-term FDIC insured CD, regardless of the low yield. Beyond that, however, there are a variety of strategies that can help you earn more on your cash and short-term investments. Consider these four:

1. Consider slightly longer maturities

For money you don't need right away, consider investments with slightly longer maturities, including Treasuries, which can provide higher yields. For instance, a 12-month Treasury is currently yielding close to 0.40%, a two-year Treasury close to 1.00%, and a three-year 1.50%. Other options: longer-term FDIC-insured CDs and short-term bonds from agencies or government sponsored enterprises (GSEs). The table below illustrates how slightly higher maturities can bring higher yields. Of course, it's important that your CDs stay within the FDIC protection limits,2 and remember that, while GSEs are strongly supported by the government, in most cases, they aren't explicitly government-guaranteed options.

2. Build a short-term ladder

You can also ladder these securities and invest equal amounts across several maturity buckets. For example, with a three-year ladder, it's now possible to earn annualized returns of roughly 0.8%-1% depending on the bond type chosen (see table below). The three-year ladder strategy won't have as high a yield as buying a three-year bond outright, but it will provide periodic "liquidity events" when your principal matures. That way, if rates rise within the next 6-12 months, you'll be able to reinvest the maturing principal at higher rates.

3. Consider short-term bond funds

Investing in short-term Treasury, government, or other investment-grade bond mutual funds—which is similar to investing in ladders of securities typically maturing in five years or less—may provide higher yields while reducing interest rate and credit risk. They may also provide diversification among issuers and are generally easier to sell than an individual bond.

"As a short-term bond fund manager, I have more opportunities to look at the market and look for attractive investments," says Rob Galusza, portfolio manager of Fidelity Short-Term Bond Fund (FSHBX). "This allows me to allocate assets into higher-yielding bonds more quickly, should rates rise."

4. A more aggressive choice: floating rate or leveraged loans

If you are more aggressive and comfortable with increased credit risk and potential for principal loss, consider mutual funds that invest in floating rate bank loans, which are primarily secured loans made by banks to non-investment-grade companies. Floating rate bank loans have coupons that reset periodically, or "float," based on a fixed premium over a market rate such as the London Interbank Offered Rate (LIBOR), which is the rate that banks charge each other for loans less than one year. And in case of bankruptcy, floating rate loans are senior in standing to bonds on the balance sheets of these companies. The average yield is currently 5.26% according to the S&P/LSTA Leveraged Performing Loan Index.

"The floating rate feature of these loans helps to reduce interest rate volatility, while the combination of seniority, security, and floating rates helps to limit the price volatility of the investment," says Christine McConnell, manager of Fidelity Floating Rate High Income Fund (FFRHX).

Keep in mind the risks of floating rate loans, however. These loans are often lower-quality debt securities, and generally are subject to restrictions on resale. Also, they may not be fully collateralized, which may cause the floating rate loan to decline significantly in value.

Next steps

Despite the low interest rate environment, there are still opportunities to earn more yield by diversifying your cash and short-term investments. Remember, however that because liquidity and risk are key, money for emergencies stills belongs in a checking account, money market account or fund, or short-term CD.

Okay, not much new here. My comments: The floating rate option is not for the faint of heart. At least the article describes it as "aggressive". The longer maturities give you additional interest rate risk. If you keep it short, you can always roll it over at higher rates should they increase. (If rates go lower here, that likely signals big trouble somewhere, either in the economy, the markets or both.) It's a very tough environment for those looking for yield.