Little Things Matter Again In Managing Your Cash Reserve

by: Jim Sloan

Cash management is one of those nitpicky little tasks - sort of like John Wooden's instructions on how to put on socks and lace up shoes.

I neglected attention to short-term instruments for about 10 years, but a question from my son provided a wake-up call.

His proposed ladder was 6-month T-Bills bought monthly and rolled - worked for him but didn't beat my muni fund for me.

A friend asked a question about laddering to the Treasury 5-Year, raising the question of duration which could be combined with a ladder like my son's.

The bottom line: Rates have risen enough that attention to detail matters again with your cash reserve.

John Wooden, the great UCLA basketball coach, greeted his incoming players with a lesson on the proper way to pull on socks and lace up shoes. Wooden was a great believer in paying attention to small details, but it would be easy to dismiss his lecture on how to put on your socks and shoes as a comic bit of nitpicking except for the fact that his teams won 10 NCAA championships in the last 12 years of his coaching career including seven in a row.

The little things matter. For investors seeking alpha, one of those little things is proper management of cash.

An Email From My Son Provided A Wake-Up Call

Cash management is a good bit like putting on your shoes and socks properly. Thinking about it seems like a needless nuisance, but it is literally foundational. You'll invest better elsewhere if your cash is safe and provides the optimal safe return. I am usually pretty good about paying attention to little details, but I must confess that for the past 10 years, I have paid very little attention to choices among the various instruments for holding cash - this despite the fact that I often hold a substantial cash reserve.

Rates have been so low that there hasn't been much point in analyzing the returns from active cash management. To some degree this is because Vanguard, where I keep most of my assets, offers pretty good cash options and does the basic cash management automatically, using its Municipal Money Market Fund (VMSXX) for my taxable accounts and using either its Prime Money Market (VMMXX) or Federal Money Market (VMFXX) - its settlement fund - in Rollover and Roth IRAs.

The only time I gave any thought to cash reserves occurred when Vanguard tightened its rules on moving assets among funds, forcing me to make decisions about my cash reserve. I had to anticipate future actions and decide how to divide cash between the immediately available Federal Money Market (currently yielding 1.29%) and the more restricted Prime Money Market (currently yielding 1.45%) or the Municipal Money Market (yielding 1.02%).

While I was at it, I sometimes glanced at the rate on the Municipal Money Market fund (currently 1.03%) and did a quick calculation in my head as to how the after-tax return compared to the taxable funds for a person in my situation. It was always a pretty close comparison with the after-tax return on the Prime fund pushed more in favor of the munis because Illinois does not allow you to exclude muni income from diversified portfolios holding any assets not based in Illinois. The fact that I hold facts like these in my head probably qualifies me as a bit of a nitpicker myself.

Anyway I thought very little about alternatives for cash and near cash until I received this email from my son:

"I'm taking another look at my cash position now that yields are rising. What do think of this …"

"I've got ... in cash in my taxable account that's getting 1.25%. That's for a Schwab money market fund. I was thinking that I could slowly shift it into six-month Treasury bills. They're at 1.6% right now. I'd ladder it. I'd move a sixth of the ... into bills now and then another sixth into bills every month thereafter. Six months from now, I'd start rolling. In theory this picks me up another .35%. (He notes the improvement in cash flow.) The cash would still be accessible by selling the bills if we had a big crack where I wanted to buy something. Minor move but every dollar helps, right? What am I missing? Is there another way to do this?"

We went back and forth about our relative tax rates - mine in Illinois (which feels like hell), his in New Jersey (which really is hell, about Dante's third level down, exceeded, of course, by New York and California). In both of our cases you pay (now per the new tax law) non-deductible state taxes on munis. Our marginal tax rates differed, however. His idea seemed good for him. For me, the tax saving under the new top IRS rate just about exactly netted out to the return on the Vanguard Muni Fund. Therefore it made no sense for me to go through a lot of trouble and extend duration, albeit slightly, for nothing better than breaking even.

But that wasn't the big takeaway from our conversation. What I realized was that I had fallen asleep on a big aspect of rising rates. I was so busy gaming what rising rates would do in the cases of banks and homebuilders that I neglected to notice that the way you choose funds, strategies, and duration for cash, and near-cash now mattered again. At roughly the same moment another email question, from a fellow retiree who had been an S&P 500 CIO, extended the question.

My Friend's Question About Extending Duration

It's one thing to compare money market funds and other super-short-duration (and easy to exit) instruments and another to open the conversation to the possibility of extending duration.

For years I have owned no bonds whatever (except for I Bonds, the inflation-protected savings bond). I occasionally checked out long-term charts for the 10-Year Treasury, not with any thought to buying the bonds themselves but as part of the calculations I brought to buying or selling stocks. In the last two or three years, my interest in the 10-Year - purely as an indicator - had increased, but it never crossed my mind to buy an asset with duration that long and return so poor.

Recently, however, I have begun checking returns on some of the shorter maturities to see if I might want use them for some of my cash reserve, at least in non-taxable accounts. My cash positions are really equity money which I prefer to hold in reserve at a particular time - the present, for instance. I wouldn't own fixed income investments of significant duration as investments (as opposed to parking places) until the rates were high enough to provide real competition and balance for stocks. That's some distance away. What I had looked at was the 2-Year Treasury yield, which has been around 2%.

Here's the question I got from my friend, who is not an expert in the markets but is well informed in the way of a sophisticated businessman - and who is even more conservative than I am:

"As interest rates begin to rise and the equity market continues its unbelievable (and in my opinion unsustainable) run I am considering putting some cash into 5< year treasuries with the intent of holding to maturity. I have never used Treasury Direct but it seems like the logical choice. Any opinion?"

It was once again the kind of question that helped me put my own thinking into focus. I took a close look at the yield curve and realized that his question really involved an assumption about duration which I should begin considering seriously.

His perspective was whether to commit capital to short duration bonds at this moment with the intention of holding them to maturity. From my perspective, the question weighed the yield curve structure against the probability I would want to access the money quickly for a sudden opportunity in the market. That's the reason I don't generally own CDs - that and the fact that they don't offer much of an improvement on Treasuries at this point. There's a penalty in getting out of CDs. The penalty for getting out of a 5-Year Treasury prematurely is the risk of selling at a loss. The same concern makes me less than enthusiastic about shorter duration funds, although I occasionally check their yields.

Here's my reply:

"I have actually been considering the same thing in tax-advantaged accounts. While the 10-year is critical for comparison to stock valuations I agree that the 5-year is the cut-off where the increased yield of going out to longer maturities doesn't justify the increased duration. You only buy long duration when you think rates are great and likely to fall with persistence, think 1982 and for a decade or so after. You have to ask yourself how much the Fed will actually raise rates in the near future, how long the economic expansion will go on without a recession, and how high short rates will go up over that period before the Fed is happy about slowing things down. One approach is laddering, of course, and 2 years gets you 2%, only .46 below 5 years as of last night. On the other hand there is a reasonably good chance that very short rates go up at least .75 over the year and the 2-year will go up along with it unless the yield curve actually goes negative. Anyway that's the outline of my thinking and the reason I might do it at any time but haven't yet. Maybe I'll take your question and write a Seeking Alpha piece about noodling the problem. The short compromise would be to do it but not all at once, spread out over a few Fed meetings. Also keep a close eye on the economic leading indicators you rely on."

When he repeated the question about using Treasury Direct, I responded that I had only used it for I Bonds, but buying ordinary Treasury Bills or Notes, there was zero cost, but didn't have the flexibility I would need if I wished to access cash for equities.

Rates have moved up a little more since that exchange with the 10-Year as of this Friday at 2.84%, the 5-Year at 2.56%, and the 2-Year at 2.16%. The first thing that stands out to me is that the .28% differential between the 5-Year and the 10-Year doesn't adequately compensate for the 5 additional years. For my friend's purposes the 5-Year may be a good choice as the top step of a ladder. For me the 2-Year is interesting.

In fact, my son's idea of laddering and rolling short-term has some appeal, although starting, perhaps, at 8 months, then 16 months, then 2 years. On average a ladder like that would yield a little more than 2% while allowing the opportunity to average up as the Fed, presumably but not certainly, raises rates. Another factor, small but significant, is that I would ramp up my equity position first in taxable accounts. Taxable accounts provide the opportunity to take a tax loss if you make a mistake in timing. In non-taxable accounts a loss is a loss - there's no tax write-off. Thus my preference for holding longer duration cash in non-taxable accounts, which would be the last place I would add equities.

If all the numbers are confusing, you may want to take the time to reread slowly. They aren't recommendations but suggestions of how to think about the most lowly part of one's portfolio: the cash reserve. If you have questions or suggestions, I'll be happy to respond in comments.

The big takeaway: paying close attention to the instruments and strategies for your cash reserve is starting to matter again.

A note on feet: Twenty-seven years ago I lost a very important tennis match (regional rankings on the line) because of insufficient attention to my feet. I was cheap about shoes and unwilling to pay up for professional orthotics. I had tried to get by on drugstore inserts, Shoo Goo modifications, and doubled Thorlo socks. I beat the tough guy in the semis and then lost to a lesser player in the finals because I had an effective range of movement of about five meters. I said never again.

I now pay north of $500 for good orthotics. I do the awful job of nail-trimming regularly. When I get out of the shower in the morning, the first thing I do is check the bottoms of my feet to see if they need Tinactin or just Curel moisturizer. I put the rubber toe dividers (two or three bucks) between my first and second toes. I check to be sure that there are no holes or worn places in my Thorlos. I pull them on carefully. Then I put on my expensive Asics running shoes (OK for tennis teaching, and they accommodate orthotics) and do the lacing for driving to the court to be followed up by a tightening before actually going out to hit balls. You had it right, Coach Wooden. Feet are everything. You win in life by doing the little things properly, from the bottom up.

Disclosure: I am/we are long VMFXX, VMXXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.