MONEY MARKET FUNDS and other cash investments are paying interest rates close to zero. This is at a time of turmoil in society and in the economy. This is at a time when both stock and bond markets are at high prices. It seems like we have to choose between collecting very low yields on cash or buying investments with far greater risk.
An alternative to these extremes: How about a “short-term barbell” to hold money you don’t currently want to invest or don’t yet need to spend? Among bond investors, barbells are a popular strategy. The idea is to split a bond portfolio between short-term and long-term bonds, in an attempt to balance yield with interest rate risk. By combining the extra yield offered by long-term bonds with the stability offered by short-term bonds, the holder of a bond barbell hopes to earn a slightly higher return than that offered by intermediate-term bonds.
A short-term barbell involves a similar balancing act. It sticks to short-term maturities, thereby reducing the potential price hit from a rise in interest rates. But it also holds different types of short-term securities, so it fares reasonably well whether interest rates rise or fall. The barbell has short-term variable interest rate debt investments at one end and short-term fixed rate debt at the other.
What kind of securities are we talking about? The variable rate end might hold online savings accounts, where the interest rate paid will change in line with market conditions. Most are insured up to $250,000 by the FDIC. An online FDIC-insured savings account is kind of like a Treasury money market fund, but with income subject to state income taxes along with federal taxes. The good news: Online savings accounts are currently paying noticeably higher rates than money market funds.
The fixed rate end of a short-term barbell holds ultra-short bonds. These are available as mutual funds or exchange-traded index funds. We’re talking about funds holding taxable or tax-exempt fixed-rate bonds with an average maturity of around one year. Favor funds with low annual expenses, which should pay you a higher after-tax yield than an online savings account. Ultra-short bond funds will suffer some price fluctuations, but these will be modest.
The balancing of online savings accounts with ultra-short bond funds provides a bit of interest rate hedging. If rates rise, income will likely rise from online savings accounts, helping to offset the price drop on the fixed rate ultra-short bond funds. If rates fall, income will fall from online savings accounts, while ultra-short bond funds should enjoy a modest rise in price. The net result should be less volatility in your total short-term bond portfolio’s value.
A short-term barbell with limited risk can improve your income compared to bank cash accounts and money market funds. Think of it as a “shelter in place” for your investable cash until you need to spend the money involved or you’re ready to buy riskier investments.
Tom Welsh is a certified management accountant in Raleigh, North Carolina. He has been the chief financial officer at several manufacturing companies and is founder of Value Point Accounting, where he helps businesses manage product and customer profitability. His previous articles were Five Lives and Pay to Play. Tom can be reached at email@example.com.