Suppose you have some spare cash lying around. Maybe you need the money in a few years or maybe you are just reluctant to invest it in anything very risky at this time. Where would be a good place to park the cash?
Federal Reserve Sets the Tone
On Tuesday August 10th, 2010, The Federal Reserve Board FOMC met. Their announcement was basically that they would maintain Quantitative Easing (QE) at the current level
If you recall from last year, the Fed bought about 1 trillion dollars worth of Mortgage-Backed Secuties (MBS) from troubled banks. With 30-year fixed interest rates at about 4.5% (See Bloomberg Key Rates or bankrate.com for best rates) some mortgages will be paid off early. Now when the fed originally bought these MBS, the plan was to let them retire as they were paid off, thus gradually removing the QE. The changed position is that now the fed will take the proceeds from the MBS’s and use it to buy Long-Term Treasuries, maintaining QE at the same level.
The implication here is that interest rates will remain low for a while. Short-term treasury rates have already been at about rock bottom (2-year at 0.52%), but the Treasury yield curve has been relatively steep. Well now it looks like the yield on Long-Term Treasuries may come down further. The 10-year and 30-year are currently at 2.72% and 3.94%
Money Market Mutual Funds and Bank CDs
The normal place to park cash is in either a Money Market Mutual Fund (mmmf) or in FDIC-insured Certificates of Deposit (CDs). This is usually the safest place because you can expect top get 100% of your money back.
But right now Vanguard Prime Money Market is yielding only 0.13%. That means $10,000 will only earn $13 interest in a year! And the best 1-year CDs are yielding about 1.5%. But don’t expect those rates for brokerage CDs. The best New Issue 1-year CD through Vanguard are only offered at 0.8%. 2,3,5-years CD are 1.45/1.90/2.45 percent.
Short-Term Bond Funds Another alternative is a short-term bond fund. But unlike money market funds or CDs, you can loose money if the Net Asset Value (NAV) declines. However it may be worth the risk.
I looked at all the Vanguard short-term bond funds and focused on the Vanguard Short-Term Investment Grade Bond Fund (VFSTX) as a place to park cash. This fund holds mostly investment-grade corporate bonds with 1 to 5 year maturity. It also holds some Treasuries and agency bonds. (It’s benchmark is the Barclay’s US 1-5 Year Credit Index)
|Number of bonds||1179|
|Yield to maturity||2.6%|
|Average maturity||3.2 years|
|Average duration||2.2 years|
What to expect
The YTM is 2.6% so this is the expected return over the 3.2 years average maturity. However, the NAV can go up or down, so you can get a better or worse result.
Currently the NAV is 10.83. In one year, if the NAV is still at 10.83, you will make the distribution yield which is about 3.3%. If it is higher, you will have a higher return. If NAV is lower, less than 3.3% return. Since the average coupon 4.0% is higher than the YTM 2.6%, the average bond in the fund is trading at a premium and can be expected to loose value as the bonds approach maturity.
Interest Rate Risk
Rising interest rates can impact the NAV. Multiplying the average duration (2.2 years) by the rise in interest rates tells you that a 1% rise in interest rates over the next year would reduce the NAV by 2.2%. The 3.3% distribution yield will offset the NAV loss and you would still show a 1.1% gain. Bigger jumps in interest rates would reduce the NAV more.
Given the state of the economy and the FOMC’s statement, it doesn’t look like short-term rates will be rising anytime soon.
Credit Risk or How Low Can the NAV Go?
I think credit risk is more worrisome than in interest rate risk. When the stock market tanks, credit spread on corporate bonds tend to widen driving down bond prices..
During the credit crisis of 2008, this fund lost -9.2% and got down to a NAV of 9.57. That shows that a -10% loss is a possibliity in a credit crisis. However, this loss was not permanent, only temporary, when prices were depressed during the crisis.
But looking at a chart of the NAV of this fund you see that it has normally stayed in the range 10.30 to 10.98. Investment-grade bond funds are not expected to suffer permanent loss of principle.
Year-to-Date (YTD) this fund is up 2.27% and Year-over-Year it is up 4.63%. What the market giveth, the market can taketh away. So it would not be surprising to see the NAV down 3% to 5% a year from now. However you will collect about 3.3% in interest, so for those case the return would range from a -1.7% loss to a 0.3% gain.
Summary of What To Expect
The expected return is 2.6%, The likely range would about -2% to +4%. In the worst case, if there is another credit crisis, then a -10% temporary drawdown could be experienced. Not pleasant, but I don’t think there is risk of permanent loss of principle with this fund.
Parking and Waiting
In a previous article, Investing In A Low-Return World, I wrote that there were no good investing choices available. I asked if it is worth investing in anything at all?
Since that article was written, interest rates have fallen further and stocks have risen higher. So, if anything, there are even fewer opportunities now than then. So last Friday I sold a lot of risky asset including long-term bonds, equities and gold and moved into the ST Investment-Grade Bond Fund and CDs.
|ST BONDS & CASH||19.5||36.6|
The current plan is to park in ST bonds and CDs while waiting for a better opportunity. This may take a while. Maybe by 2011 or 2012 there will be better opportunities.