Don't Keep Your Cash In Cash

2/16/2009


For many investors, holding a lot of cash used to make sense. But in the current environment, returns on “cash” are so low that the strategy doesn’t pay.

We recommend that investors hold 30% to 40% of equity portfolios in short-term reserves. But for many investors, bond funds make more sense than traditional cash holdings. The average taxable money-market fund yields only 0.43%, and those that invest strictly in Treasury securities pay less than 0.10%. Most industry watchers expect short-term interest rates to remain low.

Sure, money markets offer investors easy access to their cash, as well as peace of mind. The value of each share is pegged at $1 and should not vary. But with yields at historic lows, investors seeking higher returns on short-term reserves should consider alternatives. The trade-off, of course, is that higher yields come with more risk.

In the table below we list 12 attractive income alternatives from two general bond categories — government and corporate. We list both traditional mutual funds and similar exchange-traded funds (ETFs). Funds investing in Treasury and agency securities (like mortgage-backed bonds from Ginnie Mae, or GNMA) are the most conservative, as government backing gives the holdings zero default risk. At the opposite end of the spectrum are high-yield funds that invest in junk bonds.

STANDOUT BOND FUNDS
Category
Fund (Price; Ticker)
Est.
Dividend
Yield
(%)
12-Mo.
Total
Return
(%)
Exp.
Ratio
(%)
Avg.
Credit
Quality
Duration
(Years)
Government Bonds
Vanguard Short-Term Treasury
($11; VFISX)
1.5
4.3
0.22
AAA
1.8
iShares Barclays 1-3 Year
Treasury ($84; SHY)
0.5
4.0
0.15
AAA
1.8
Average Short-Term Government
2.0
3.1
0.89
AAA
2.3
Vanguard GNMA ($11; VFIIX)
4.5
6.1
0.21
AAA
3.8
iShares Barclays MBS
($105; MBB)
3.6
6.2
0.25
AAA
2.6
Average Mortage-Backed Bond
4.0
6.2
0.70
AAA
4.3
Vanguard Interm.-Term
Treasury ($12; VFITX)
2.2
7.4
0.26
AAA
4.7
iShares Barclays 3-7 Year Treasury
($114; IEI)
1.5
7.7
0.15
AAA
4.2
Average Intermediate-Term Government
1.7
2.7
1.04
AAA
4.2
Corporate Bonds
Vanguard Short-Term Invest.-Grade
($10; VFSTX)
5.2
(4.2)
0.21
AA
1.7
iShares Barclays 1-3 Year Credit
($101; CSJ)
4.7
2.1
0.20
A
1.9
Average Short-Term Corporate
4.4
(4.6)
0.91
AA
2.1
Vanguard Interm.-Term Inv.-Grade
($9; VFICX)
6.1
(7.0)
0.21
A
4.7
iShares Barclays Interm. Credit
($97; CIU)
5.7
(1.4)
0.20
A
4.2
Average Intermediate-Term Corporate
4.6
(5.5)
0.97
AA
4.5
Vanguard High-Yield Corp.
($5; VWEHX)
10.6
14.0
0.25
BB
4.5
iShares iBoxx $ High Yield
Corp. ($74; HYG)
14.2
(15.5)
0.50
B
4.7
Average High Yield (Junk Bond)
10.9
(19.7)
1.20
B
3.9

Short-term bonds generally offer a higher degree of safety than intermediate or long-term bonds. A fund’s duration measures interest-rate risk; the shorter the duration, the less sensitive a fund is to shifts in interest rates. For example, duration of two years means a fund would lose roughly 2% of its value if rates rose by one percentage point.

Recommendations
We favor Vanguard funds partly because of their low expense ratios.  Among government bond funds, very conservative investors should consider Vanguard Short-Term Treasury ($11; VFISX). The fund, yielding 1.5%, has had just one down year over the past 15 — a 0.8% loss in 1994. Risk-averse investors looking for more income should consider Vanguard GNMA ($11; VFIIX), which focuses on Ginnie Mae mortgage securities backed by the U.S. government and yields roughly 4.5%. The fund rose 7.2% last year, and its only down year over the last 15 was a 0.9% decline in 1994. Vanguard Intermediate-Term Treasury ($12; VFITX) is a solid choice for investors seeking safety but uncomfortable holding mortgage-backed securities. The fund, which invests at least 80% of its assets in Treasurys, lost money in just two of the last 15 years, 1994 and 1999.

The corporate bond funds listed on page 1 offer higher yields but entail more risk. Investors willing to test those waters should consider Vanguard Short-Term Investment-Grade ($10; VFSTX). Yielding about 5.2%, the fund holds mostly high-quality bonds, with 39% of its nearly 800 holdings rated AAA and about 97% rated investment-grade. Last year, the fund lost 4.7% — the first down year since 1994. The fund’s high-quality, low-duration bonds have solid rebound potential. Investors who can take on additional risk to gain more income should consider Vanguard Intermediate-Term Investment-Grade ($9; VFICX). Down 6.2% last year, the fund yields 6.1%. Finally, aggressive investors should find the 10.6% yield of Vanguard High-Yield Corporate ($5; VWEHX) appealing. The junk-bond fund, which tumbled 21.3% last year, has had three down years over the last 15. The fund holds nearly 250 bonds, with average credit quality of BB and average duration of 4.5 years. 

FORECASTS FUND RECOMMENDATIONS
Through Feb. 10, our recommended Growth Portfolio declined 6.3% this year, versus a loss of 8.5% for its benchmark portfolio and a loss of 8.2% for the S&P 500 Index. The conservative Portfolio fell 4.6%, versus a loss of 6.6% for its benchmark.
— Year-to-Date —
—— % of Portfolio ——
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Baron Asset ($32; BARAX)
(9.0)
E
6
7
Dreyfus Small Cap Stock Index
($12; DISSX)
(12.5)
E
6
8
Fidelity Export & Multinational
($14; FEXPX)
(5.7)
E
6
8
Fidelity Leveraged Co. Stock
($14; FLVCX)
(4.0)
B
0
0
Heartland Select Value
($17; HRSVX)
(5.2)
A
5
9
Heartland Value Plus
($18; HRVIX)
(5.1)
A
7
8
Northern Small Cap Value
($9; NOSGX)
(14.4)
E
0
0
T. Rowe Price Int’l Discovery
($22; PRIDX)
(7.9)
C
5
7
T. Rowe Price New Horizons
($17; PRNHX)
(3.3)
A
0
0
USAA High-Yield Opportunities
($6; USHYX)
4.2
E
7
5
Vanguard 500 Index
($76; VFINX)
(8.2)
D
7
7
Vanguard Dividend Growth
($10; VDIGX)
(5.5)
A
8
10
Vanguard Emerging Mkts. Stock
Indx. ($14; VEIEX)
(4.2)
B
0
5
Vanguard GNMA ($11; VFIIX)
0.3
B
6
0
Vanguard Inter.-Term Tax Exempt
($13; VWITX)
4.5
C
0
0
Vanguard International Value
($21; VTRIX)
(10.2)
B
8
9
Vanguard Short-Term Invest.-Grade
($10; VFSTX)
2.3
A
0
0
Vanguard Total Bond Mkt. Index
($10; VBMFX)
(0.3)
D
20
0
Vanguard Wellesley Income
($18; VWINX)
(4.2)
E
0
7
Vanguard Wellington ($23; VWELX)
(4.7)
D
9
10
* Rankings through Feb. 10 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. c Closed to new investors.

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