For most investors, it makes sense to have a highly liquid short-term portfolio allocation to meet near-term cash needs, provide an “emergency fund” reserve against unexpected loss of income, or take advantage of attractively priced investment opportunities as they arise. There are a variety of ways to invest for short-term needs and goals, including bank savings accounts and certificates of deposit (CDs) or investment products such as money market mutual funds and low duration¹ bond funds.

It’s important for individuals to periodically review their full portfolios—including any short-term allocations—to determine whether their investments are still aligned with their objectives. If not, they may be missing potential opportunities to improve yields or enhance liquidity.

We believe investors should consider two key factors when structuring short-term allocations: anticipated cash needs time frames and risk tolerance. Expected short-term cash needs or a desired buffer against unexpected financial setbacks should determine the amount of risk an investor is willing to take. If saving for a down payment on a first house, for example, one is likely to have a shorter time horizon and a lower tolerance for risk than an investor saving for retirement.

Creating a Tiered Liquidity Structure

Our recommended approach to short‑term liquidity management is to tier or align the assets in the short-term allocation based on the anticipated time frames for future withdrawals.

Tier One: Emergency Funds

Funds to meet an investor’s immediate cash needs would fall into tier one. This category should include the most liquid vehicles—assets that an investor could reasonably expect to access at any time, potentially as an emergency fund.

"Money market mutual funds generally offer the greatest level of flexibility and liquidity along with the lowest risk of principal loss among the available short‑term investment products."

Many investors rely on bank checking or savings accounts as well as bank money market deposit accounts to hold their most liquid funds. While these accounts are insured (up to USD 250,000) by the Federal Deposit Insurance Corporation (FDIC) against the risk of bank failure, and their principal values do not fluctuate as interest rates rise or fall, the interest they accrue typically is significantly lower than the yields on longer-term bank instruments such as CDs. Moreover, high minimum balances may be required to keep a bank account open.

Money market mutual funds are a popular alternative to bank accounts as vehicles for liquid cash reserves. Money market mutual funds generally offer the greatest level of flexibility and liquidity along with the lowest risk of principal loss among the available short-term investment products. In general, there are three types of money market mutual funds available:

• U.S. Treasury funds
• Government funds
• Retail prime funds

While money market mutual funds do not guarantee an investor’s deposit like an FDIC-insured bank account or CD and it is possible to lose money, U.S. Treasury and government money market mutual funds are required to invest at least 99.5% of their assets in fixed income securities backed by the full faith and credit of the U.S. government. Retail prime money market mutual funds can invest in a broader range of short-term instruments, including commercial paper issued by corporations.

Tier Two: Cash Needed in the Next Six to 12 Months

Funds for near-term cash requirements—which we would define as cash needed within the next six to 12 months—make up tier two of a short-term allocation. This could include cash accumulated for a down payment on a home purchase intended to be made within that time frame. Tier two investments also may include money market mutual funds, but more typically they are low duration fixed income vehicles such as ultra short-term and short-term bond funds.

These funds are professionally managed fixed income portfolios that invest in a broadly diversified set of fixed rate and floating rate bonds that generally mature in three years or less. These holdings may include government debt, securitized debt, or corporate bonds. Compared with money market mutual funds, ultra short-term and short-term bond funds offer investors high to moderate levels of liquidity plus the potential to obtain higher yields and returns with the addition of interest rate risk and credit risk.

Tier Three: Liquidity Needs Beyond 12 Months

Longer-term liquidity needs (cash required beyond the next 12 months but within the next 36 months)—which could include money for purchasing a home—could be funded by assets in tier three. Typical tier three vehicles could include bank CDs or short-term bond funds.

Bank CDs generally offer competitive rates, but they also require that savings be set aside or locked up for a specified period. If the investor’s cash needs change, early CD withdrawals typically are subject to a penalty. Investors can seek to reduce that risk by investing in multiple CDs with different maturities. “Laddering” CDs in this way may help improve liquidity but could also reduce the average yield on tier three assets.

Like ultra short‑term bond funds, short‑term bond funds can combine high to moderate levels of liquidity with moderate levels of principal risk. The somewhat longer duration of these funds potentially can improve yields while adding only a modest degree of additional interest rate risk to principal compared with ultra short‑term bond strategies.

Laddered Portfolios

Some investors prefer to manage their fixed income investments by creating laddered portfolios of short-term securities, such as Treasury bills. As with bank CDs, investors can structure these portfolios to include a range of maturities, providing liquid access to cash over different time periods. Funds not needed immediately can be rolled from maturing securities into newly purchased ones.

If done properly, investing directly in laddered fixed income assets can generate relatively attractive yields. However, like investing in individual stocks, investing in individual fixed income securities may require a degree of skill on the part of both investors and their brokers. Constructing and maintaining laddered portfolios also may entail a significant time commitment to researching and monitoring securities.

Comparing Investment Options

Figure 2 compares average yield and duration for each of the short‑term vehicles discussed above. As highlighted in the chart, money market bank accounts offer relatively high liquidity and typically provide higher yields than bank checking and savings accounts. While two‑year bank CDs typically feature competitive yields, on average, relative to low duration vehicles such as money market mutual funds, they also require investors to tie up their funds for those two years or face early withdrawal penalties.

Although three-month Treasury bills provided higher yields than money market bank accounts, directly investing in individual fixed income securities poses its own challenges, as noted above. We believe this strategy is best suited for more experienced investors. Ultra short‑term bonds provided the most attractive yield and duration combination among the alternatives shown here as February 28, 2023.

Tiering Can Help Align Assets With Cash Needs

With short-term rates well above longer‑term yields and the Federal Reserve (Fed) expected to keep hiking interest rates, this may be a good time for investors to review cash and short‑term allocations to see if they are still appropriate given their needs and objectives. Investment tiering is a simple, but powerful, concept that investors can use to align their assets with their expected cash needs.

In our view, investors are most likely to benefit from short-term allocations that combine relatively low fees, competitive yields, high levels of liquidity, and limited exposure to interest rate risk. We believe most investors would do well to avoid illiquid vehicles or those with lengthy lockup periods for short-term investments, especially if there is a significant possibility that your financial situation or cash needs may change in the near future.