For Risk-Free Income, Money Market Accounts Still Have an Edge Over Treasuries
July 07, 2009
One of the most important and fundamental steps in managing your money is to clearly define the role that each account or investment is supposed to play. You should have a diversified range of investments, but that diversification will only work properly if each investment is a good fit for its intended role. For the portion of your portfolio assigned to provide risk-free income, money market accounts remain a particularly good fit right now.
This question of defining and filling roles with precision can be especially challenging with income investments--and especially when interest rates in general are low, as they are now. Money market rates won't set your world afire these days, and there are certainly investments offering higher interest rates. However, as you reach for those higher interest rates, you will be giving up some of the stability and security of your principal. Once you do that, this portion of your portfolio is no longer providing risk-free income.
Defining "Risk-Free"
It's worth pausing here to define what people generally mean when they say something is "risk-free." This expression usually means that the investment or account is guaranteed against loss of principal and/or won't fluctuate in value. It's worth noting, however, that there are other forms of risk. No investment is truly free of all forms of risk. Investments that provide income and stable principal have no growth component to protect against inflation, and also may be susceptible to diminishing income production if interest rates fall.
This is why diversification is important. You should have other investments to provide growth to counteract inflation, but when it comes to the stable portion of your portfolio, you want to make sure you have not compromised on security.
Which raises a natural question--don't Treasury bonds provide income with guaranteed principal? They do, but only if you hold the bond to maturity. In the meantime, they are freely traded, and subject to market fluctuations. The longer the term of the bond, the more it may fluctuate. So, once you get beyond very short-term Treasuries, they are not such a good fit for the stable portion of your portfolio.
Changes in Treasury Yields
This question about Treasuries is all the more pertinent with Treasury yields having risen lately, making them a more tempting investment. Still, the biggest jump in Treasury yields has come in the five-year range. Moving out that far would certainly make you susceptible to some fluctuations in value. Move down into shorter-term Treasuries, and yields fall off considerably.
Where Money Market Rates Fit In
On first glance, money market account rates may not seem to compare well with Treasuries. As of mid-June, money market rates averaged 1.38%. This was a little better than you could do in a 2-year Treasury, but clearly less than the yield on a 3-year Treasury. However, if you shopped around for the best money market rates, you would find that some money market offers were around 2.25%. To get a better yield in Treasury bonds, you'd have to move out into the 5-year range--and again, that would mean accepting some fluctuations in principal.
In short, for income with stability, money market accounts represent a competitive option right now -- but only if you shop around for the top money market rates.
