Fixed Income

Getting More Out of Your Cash Investments

September 17, 2019
Tiered liquidity structures offer a simple but powerful approach to investing.

Key Points

  • We believe many investors may be overlooking opportunities to improve yields and/or enhance liquidity in their cash or short-term allocations.
  • In our view, investors should consider two key factors when structuring short-term allocations: their anticipated future cash needs and their tolerance for risk.
  • Our recommended approach is for investors to tier or align their short-term allocations based on the expected time frames for their future cash withdrawals.

For most individual investors, it makes sense to include a highly liquid short‑term allocation in their portfolio to meet near‑term cash needs and provide a reserve against unexpected loss of income. Highly liquid assets may be invested in a variety of short‑term vehicles, including bank savings accounts and certificates of deposit (CDs) or investment products such as money market mutual funds and low‑duration fixed income funds.

“While individuals may review their portfolios periodically to determine whether their longer‑term allocations are still aligned with their objectives, we believe many investors may be overlooking their cash or short‑term allocations,” says Joseph Lynagh, portfolio manager of the T. Rowe Price Ultra Short-Term Bond Fund. “As a result, they may be missing potential opportunities to improve yields and enhance liquidity.”

Two key factors should be considered when structuring short‑term allocations: anticipated cash needs and risk tolerance. How much risk investors are willing or able to take should be determined by their expected short‑term cash needs or by the amount of their desired buffer against unexpected financial setbacks. Investors saving for an emergency fund or a down payment on their first house, for example, are likely to have a shorter time horizon and a lower tolerance for risk than investors saving for retirement.

Creating a tiered liquidity structure

One recommended approach to short‑term liquidity management is to tier or align the assets in your short‑term allocation based on the anticipated time frames for future withdrawals. Investment tiering is an effective strategy that can be applied to many different savings goals. (See “Creating a Tiered Liquidity Structure” for the basic concept, as well as some of the investment vehicles typically used in each tier.)

TIER ONE
Funds to meet an investor’s immediate cash needs.

This bucket should include an investor’s most liquid vehicles, assets that he or she could reasonably expect to access at any time. Many investors rely on bank checking, money market, or savings accounts to hold their most liquid funds. While these accounts are insured (up to $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 typical amount of interest they accrue is significantly lower than the yields on longer‑term bank instruments such as CDs.

Money market mutual funds are a popular alternative to bank accounts as vehicles for liquid cash reserves. In general, there are three types of money market mutual funds available to individual investors—U.S. Treasury, government, and retail prime funds. In our view, money market mutual funds offer the greatest level of flexibility and liquidity among the available short‑term investment products.

While money market mutual funds do not guarantee an investor’s deposit like an FDIC‑insured bank account or CD, U.S. Treasury and government money market 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.

We believe many investors may be overlooking their cash or short‑term allocations. As a result, they may be missing potential opportunities to improve yields and enhance liquidity.

- Joseph Lynagh, Portfolio Manager, T. Rowe Price Ultra Short-Term Bond Fund

TIER TWO
Funds for near-term cash requirements, defined as cash needed within six to 12 months.

Tier two investments also may include money market mutual funds, but more typically they are composed of low‑duration fixed income vehicles such as ultra short-term and short‑term bond funds.

Ultra short-term and short‑term bond funds are professionally managed fixed income portfolios that invest in a broadly diversified set of fixed and floating rate bonds. These holdings may include government debt, securitized debt, or corporate bonds. The T. Rowe Price Ultra Short‑Term Bond Fund typically invests in securities with maturities of six months to one year, while the T. Rowe Price Short‑Term Bond Fund typically invests in securities with maturities between 1.5 and 2.3 years.

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 performance with the addition of exposure to interest rate risk and credit risk.  

TIER THREE
Funds for longer-term cash needs beyond the next 12 months but before the end of the next 36 months.

Typical tier three vehicles could include bank CDs or short‑term bond funds. Bank CDs generally offer competitive rates, but they also require investors to lock up their savings for a specified period of time. If the investor’s cash needs change, early 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 also could reduce the average yield on the investor’s tier three assets.

As with 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 the principal compared with ultra short‑term bond strategies.

Laddered portfolios

Some investors prefer to manage and own their fixed income investments by creating laddered portfolios of short‑term securities, such as Treasury bills. As with bank CDs, these portfolios can be structured to include different maturities, providing liquid access to cash over different 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 individual investors and their brokers. Constructing and maintaining laddered portfolios also may require a significant time commitment to research and monitor securities.  

Investment tiering is a simple but powerful concept that investors can use to align their assets with their expected cash needs.

Comparing alternatives

Money market accounts offer relatively high liquidity and typically provide higher yields than bank checking and savings accounts. (See “Comparing Short-Term Investment Vehicles.”) While two‑year bank CDs typically feature competitive yields, on average—relative to low-duration vehicles such as money market funds—they also require investors to face possible early withdrawal penalties.

Although three-month Treasury bills provide somewhat higher yields compared with money market accounts, directly investing in individual fixed income securities poses its own challenges—as noted previously—and we believe should be reserved for more experienced investors.

In our view, individual investors are most likely to benefit from short‑term allocations that combine competitive yields, high levels of liquidity, and limited exposure to interest rate risk.

- Whitney Reid, T. Rowe Price Fixed Income Portfolio Specialist

Planning ahead

The Federal Reserve has indicated it does not expect to raise interest rates for the remainder of 2019. Meanwhile, the Treasury yield curve (the spread between shorter‑ and longer‑term interest rates) is flat or even inverted out to five years. Therefore, now may be a good time for individual investors to review their cash and short‑term allocations to see if they are still appropriate given their financial 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, individual investors are most likely to benefit from short‑term allocations that combine competitive yields, high levels of liquidity, and limited exposure to interest rate risk,” says Whitney Reid, a T. Rowe Price fixed income portfolio specialist. “We believe most investors would do well to avoid illiquid vehicles or lengthy lockup periods, especially if there is a significant possibility that their financial situations and cash needs may change in the near future.”

Risks—Retail Money Market Mutual Funds: You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Government Money Market Mutual Funds: You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

While U.S. government-backed securities generally are considered to be among the highest credit quality, they are subject to market risk. The primary source of risk is the possibility of rising interest rates, which generally cause bond prices, and a bond fund’s share price, to fall.

Ultra short-term bond funds and short-term bond funds are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. The funds involve more risk than a money market mutual fund and are not subject to the same diversification and maturity standards. The net asset value will fluctuate and investing in these products could result in the loss of principal.

Additional Disclosures

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of August 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

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