"Cash is trash" is commonly heard amid the fervor of stock market rallies, like the one last year. Cash was a worse option than stocks or just about anything else.
But that interjection continues to be heard for another reason altogether, not merely as an implicit rebuke for staying on the sidelines, but also as an explicit characterization: Cash today earns virtually nothing.
Still, people hold cash. Some don't know what else to do. They're afraid to throw money into a stock market that gained more than 30% in 2013 and has pulled back in 2014. Others may be waiting for a perceived entry point. There are many reasons people hold cash.
And doing so used to pay off. At least we thought it did. As long as money-market rates exceeded the inflation rate, we were gaining purchasing power on our cash. That's not true today. Bank money-market rates are at 0.11%, while the inflation rate (the December number) is at 1.5%. Cash is losing the battle with inflation, and that's why it's trash.
Can cash be parked elsewhere for a better return than those offered by money-market accounts or funds? I think so, but it's a threshold matter to thereby avoid mischaracterizing "cash." For an investment to retain sufficient cash attributes, it must be 1) preserved, and 2) liquid.
An investor's cash holding is, by definition, not at risk (disregarding here the unscrupulous or incompetent custodian, or foreign exchange effects). For our purposes, cash retains a static nominal value, unmoved by daily domestic markets.
Thus are money-market funds, which retain a constant price of a dollar, considered virtual cash with a yield bonus. Bank money-market accounts, too, are considered cash because they are simply demand deposits, again with a yield bonus.
Both of these money-market instruments have constant principal values and are thoroughly liquid. They are virtual cash (USD, of course, not virtual Bitcoin or the like). Therefore, in looking for better yields for our cash, we have to be certain that any alternatives retain such cash-like features.
How about short-term bond funds, like Vanguard Short-Term Investment-Grade (VFSTX)? It has an average credit quality of A, so any defaults of the underlying holdings are unlikely. At 0.20%, the expense ratio is tiny, which is typical of Vanguard funds. And the yield (annualizing the latest monthly dividend) is 2%. What's not to like?
Well, there's a price to be paid for a yield that is almost 20 times that of a bank money-market account, and it's called "duration," a measure of a bond fund's sensitivity to interest rate changes. The average duration of VFSTX is 2.33, which means that a 1% rise in interest rates will theoretically cause a 2.33% decline in the value of your investment. Not only would that would wipe out a whole year's worth of earned interest, it would penetrate your 2% yield and dig into the principal value.
That, most certainly, is not "cash-like." And the case is the same with VFSTX's ETF companion, the Vanguard Short-Term Corporate Bond Index (NASDAQ:VCSH), which has a similar profile - and an even higher average duration of 2.79.
How about all-the-rage bank-loan funds, like the PowerShares Senior Loan Portfolio ETF (NYSEARCA:BKLN)? Money has been pouring into this category because of the 4% yields, accompanied by durations of virtually zero (resulting from underlying corporate loans that mature every 30 days or so). How can an investor go wrong with such a great yield and almost nonexistent interest rate risk?
This time, the catch is in the credit quality component. The underlying loans are tantamount to junk bonds. Yes, that considerable credit risk is mitigated by the short maturities of the loans, but it isn't eliminated. There may be a place in an income portfolio for bank loan funds, but they certainly cannot be considered a cash substitute.
Another possibility might be short-term, target-maturity funds. The Guggenheim BulletShares 2014 High Yield Corporate Bond ETF (BJSE) yields about 3% (again, annualizing the latest monthly dividend). And since it matures in less than a year, shouldn't that offset the possibility of underlying bond defaults? Well sure it does, but not enough so that it can be considered nearly equivalent to cash. It's a junk bond fund.
OK, then, let's see if we can tweak that niggling problem of credit quality, which, you will remember, is the most important criterion for a near-cash substitute. Staying in the Guggenheim family, we find the BulletShares 2014 Corporate Bond ETF (NYSEARCA:BSCE), which holds only investment-grade bonds. Credit quality? Check.
Duration? Well, it's reported as 0.50, and we know that the fund matures by the end of 2014, so its holdings are certainly short-term and therefore not overly sensitive to rate fluctuations. The principal value should remain stable for the remainder of the fund's short life. That's cash-like.
Liquidity? Because it's an ETF, instead of a mutual fund that might impose frequent-trading restrictions, you can sell your shares at any time, as often as you want. And your broker's $7-$10 commission is negligible for four-figure balances -- unless you deposit and withdraw frequently, so don't do that.
The yield? Well, again, cash-like means the investment must be low-risk. And low risk means low reward. In the case of BSCE, the reward is a yield of about 0.7%. And even after accounting for a premium-to-net-asset-value of 0.27% (as of Feb. 20), it provides four times the yield on the average bank money-market account. That makes a short-term, target-maturity corporate bond ETF, like BSCE, an attractive and acceptable alternative to cash.
Now, if you're willing to put up with just a modicum of inflexibility (a limit of six withdrawals per month), you can do much better with an online bank savings account. For example, GE Capital Retail Bank offers a 0.90% savings account. That's more than eight times the national average for bank money-market accounts. They're FDIC-insured up to $250,000 per depositor, and of course, there's no volatility.
These are great for people who just want to hold a quantity of accessible cash, but they're a bit cumbersome for converting to securities. You'd have to withdraw and transfer the funds from the bank to your broker, and so it can take a few days for the funds to become available in your brokerage account.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long VCSH, BKLN, BSJE, BSCE, VFSTX.