With short-term interest rates at very low levels, many are wondering if there is any way to earn a higher return on their cash balances. We generally recommend that clients maintain an emergency reserve of 3-12 months worth of after-tax living expenses. The specific amount varies by client and depends on a number of factors such as the level and predictability of your income as well as your personal preference. Many clients choose to meet their liquidity needs by keeping a home equity line of credit available, and keeping their cash invested with a long-term focus at their desired asset allocation.
This column will focus on how to get a little more yield on an existing cash balance. Currently, money market rates at Fidelity and Schwab are almost zero. As of last week, the national average for a 1-year certificate of deposit was 0.72%. One thing to consider for small cash balances is Series I Savings Bonds issued by the U.S. Government, which are currently earning an annual rate of 3.36% for the next 6 months.
The earnings rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the life of the bond, and the semiannual inflation rate (think “I” as in “inflation”). The 3.36% earnings rate for I Bonds purchased through April 30, 2010 will apply for their first six months after issue. The earnings rate combines a 0.30% fixed rate of return with the 3.06% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The inflation rate changes every 6 months, so your earnings rate will increase with increases in inflation. The fixed rate applies for the 30-year life of I bonds purchased during each six-month period. The 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 $5,000 per Social Security Number in electronic bonds and $5,000 in paper bonds, so a couple could purchase up to $20,000 annually.
So why would you want to invest a portion of your liquid cash in something that carries a penalty for 5 years? Because if you act by April 30, you are in effect creating a 1 year CD with a yield of about 2.45%.
Here’s how it works:
You go to your bank and buy a series of $1,000 I Bonds. For the next six months, these bonds will earn interest at an annual rate of 3.36%. The rate will then reset, but we already know what the inflation component will be since CPI-U has already been published. We just don’t know the fixed rate, which is set every six months by the Treasury. If the fixed rate stays the same at 0.30%, the earnings rate for the next 6 months will be an annual rate of 1.84%. So you could reasonably expect a return of at least 2.45% over the next year versus 0.72% in a bank CD.
What if there is an emergency and you need the money? You cannot redeem the bonds for 12 months, so you need to leave some liquid cash on hand. After 12 months, just pay the penalty and you are still ahead of where you would have been (say 1.77% yield if you cashed the bond in after 12 months and one day, versus 0.72% in a bank CD).
You can then repeat this process to create a ladder of bonds maturing at different points, say every 3-6 months. You can set up an electronic account at www.treasurydirect.gov and manage this process from the comfort of your couch. You can just deposit any paper bonds that you buy into your account and convert them to electronic form.
All I Bonds that are outstanding have the same inflation component, currently 3.06% annualized. The only difference is in the fixed rate that each bond offers. If the fixed rate increases significantly, 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).
Some other benefits of I Bonds include:
–Interest is exempt from state income tax;
–If you buy the bonds on the last day of the month, you still get interest for the full month;
–You don’t have to worry about FDIC insurance or shopping around to different banks for the best rate. I Bonds are direct obligations of the government, whereas FDIC insurance is a fund consisting of a small percentage of deposits that are covered.
Bill Hansen, CFA
April 23, 2010