With interest rates remaining at very low levels, there are few options for earning any sort of a return on cash balances.
|Charles Schwab Bank High Yield Savings||0.35%|
|Bank Money Market||1.30% (same as in my 2011 article)|
|3 Month U.S. Treasury Bill||1.12%|
|6 Month U.S. Treasury Bill||1.14%|
|1 Year CD, National Average||1.42%|
|5 Year Treasury Note||1.85% (same as in my 2011 article)|
|10 Year Treasury Note||2.26%|
|5 Year Treasury Inflation Protected Securities||0.02% (plus inflation)|
|10 Year Treasury Inflation Protected Securities||0.45% (plus inflation)|
|Series I Savings Bonds||1.96% (for the next 6 months, then 0% plus the inflation adjustment)|
One thing to consider for smaller balances is Series I Savings Bonds (“I Bonds”) issued by the U.S. Government. The new rates came out May 1, and I Bonds are currently earning an annual rate of 1.96% for the next 6 months. You can visit www.treasurydirect.gov for a more detailed description of I Bond features.
The earnings rate for I Bonds is a combination of a fixed rate, which applies for the life of the bond, and an inflation rate that changes semi-annually (think “I” as in “inflation”). The 1.96% earnings rate for I Bonds purchased through October 31, 2017 will apply for their first six months after issuance. I Bonds cannot be redeemed for 12 months after issuance, and there is a penalty of 3 months’ interest if they are redeemed before 5 years. Purchases are limited to $10,000 per Social Security Number annually, so a couple could purchase up to $20,000 per year.
What if there is an emergency and you need the money? Since you cannot redeem the bonds for 12 months, you need to leave some liquid cash on hand. After 12 months, a penalty of 3 months’ interest is deducted from the redemption value. But even after paying the penalty you would still be ahead of a bank CD, and considerably ahead if the change in inflation continues at its current level. In addition, I Bond interest is exempt from state income taxes and is tax-deferred until you redeem the bond. Also, if you buy the bonds on the last day of the month, you still get interest for the full month (I like to call this the “Mendelsohn Option”, in memory of the man who first pointed this anomaly out to me many years ago).
All I Bonds have the same inflation component. The only difference is in the fixed rate that each bond offers. If the fixed rate increases significantly in the future, just redeem some bonds and pay the penalty. Then buy some new bonds with the higher fixed rate (but remember the $10,000 annual limit on purchases for each Social Security Number). After 5 years, there is no penalty on redemption.
Another possibility for liquidity needs is a short-term, high quality bond fund. However, you should be aware that these do carry some interest rate risk. For example, a popular short-term bond fund has a current yield of 1.96% and an effective duration of 2.60 years. This means that if interest rates were to suddenly move up by 1%, the value of the fund would be expected to fall by about 2.6%. This would wipe out over a year’s worth of interest, making it a less attractive alternative for cash balances. I Bonds cannot go down in value (unless the Government fails, in which case we all will have much bigger problems to contend with). The worst that can realistically happen is if the inflation adjustment was to be negative for a period of time. In that case, there would be no interest paid on the I Bonds until the inflation adjustment turned positive. However, we believe that the probability of negative inflation over the next several years is minimal.
An examination of interest rates reveals current market expectations about inflation. We look at this by calculating break-even inflation rates over the next 5-10 years using current yields on Treasury securities. The break-even inflation rate is simply the difference between the yield on a Treasury Note of a particular maturity and the corresponding TIPS, or Treasury Inflation Protected Security.
For example, using the yields listed previously, the current 5 year break-even inflation rate is 1.83%. This is the difference between the 1.85% yield on 5 the 5-year U.S. Treasury Note and the -0.02% yield on 5 year TIPS). If you believe inflation is going to be lower than the break-even value for a particular investment horizon, you are better off in a Treasury Note. If you believe inflation is going to be higher than the calculated break-even rate, then you should purchase TIPS or I Bonds.
Bill Hansen, CFA