Cash Management in Today’s Economic Rollercoaster

As interest rates have tumbled to historic lows and perceived market risk has increased, managing cash has become an increasingly challenging task.

After the Lehman Brothers failure in September 2008, the Reserve Primary Money Market Fund did the unthinkable by “breaking the buck.” This event sent ripples through the cash management universe as investors fled to the safety of U.S. treasuries regardless of their historically low yields. Although the current period of illiquidity and frozen credit has modestly loosened, the perceived risk in the short-term fixed income market has increased. This low yield environment could possibly become the new standard since the Fed is likely to keep interest rates low in the near-term to supply added liquidity and entice investors to move out on the risk spectrum. Given the current investment landscape in which investors are reminded of the need to weigh their tolerance for risk against their tolerance for low returns, we want to summarize and compare some common cash management alternatives.

Besides hoarding cash under the mattress, investing in a U.S. treasury money market fund or individual U.S. treasury bills may be the next safest investment. However, in the current environment where many conservative investors have already made the “flight to safety,” U.S. treasury-only money market funds are yielding approximately 0.07% annually. This return is taxable at the federal level, but is state tax-exempt. Further, with projected inflation at 2.5%, investors may realize a negative net return when adjusted for inflation. This forgone yield does purchase minimized risk and principal protection by investing in securities that are explicitly backed by the full faith and credit of the U.S. government. If not held to maturity, even U.S. treasuries carry risk of investment loss, but their default risk has historically been considered insignificant.

Whereby U.S. treasuries have an explicit backing by the full faith and credit of the U.S. government, U.S. agency notes have only an implicit backing. Government money market funds holding U.S. agency notes currently yield approximately 0.46% annually. Some of the U.S. agencies include the twelve Federal Home Loan Banks, Federal Farm Credit Banks, Fannie Mae and Freddie Mac. Just like the U.S. treasuries, agency notes are only state tax exempt and are federally taxable.

Tax-exempt money market funds hold issues from municipalities. Therefore, the underlying default risk hinges on the financial strength of the issuing municipality.

Investors looking for additional yield must accept an increased level of risk. Insured bank Certificates of Deposit (CD’s) carry Federal Deposit Insurance Corporation (FDIC) protection. The FDIC is an independent U.S. agency also backed by the full faith and credit of the U.S. government. With this limited government backing, in the event of the bank’s failure, insured bank CD’s are considered a relatively safe cash management vehicle. On October 3, 2008, the FDIC temporarily increased deposit insurance coverage from $100,000 to $250,000 per FDIC insured institution through December 31, 2009. In some states, private insurance companies have been created by state statutes which provide insurance for deposits in excess of the FDIC limit for savings banks (not commercial banks). For example, in Massachusetts, at state chartered savings banks, accounts with deposits in excess of the FDIC limit are insured by Depositors Insurance Fund (DIF). Whereas FDIC is a federal agency, DIF is a private insurer specific to Massachusetts. Investors with deposits at state chartered banks should confirm with their banking representative whether any DIF-type incremental insurance exists. A three-month CD currently yields approximately 0.25% annually, and extending the maturity to one year will yield approximately 1.00% annually. Some banks have CD’s which allow a certain number of penalty free withdrawals during the term of the CD as long as a certain minimum is maintained or a checking account is linked to the CD. CD’s are generally taxable at both the federal and state level.

Tax-exempt money market funds hold issues from municipalities. Therefore, the underlying default risk hinges on the financial strength of the issuing municipality. There are some present concerns related to the difficulties municipalities and states may have balancing their budget due to declining revenues. Accordingly, to mitigate this issuer risk, a high quality and well diversified (even geographically) municipal money market fund is particularly important. Currently, municipal money market funds yield approximately 0.40% annually. Municipal money market fund income is generally exempt from federal taxes and in some cases exempt from state taxes. Under these circumstances, these funds are particularly attractive for investors in the higher marginal tax brackets. However, since certain municipal bond income may be subject to the alternative minimum tax, investors should work with their advisors to be sure they are maximizing the after-tax return on these investments.

Taxable money market funds invest primarily in the private debts of corporations, which increases the inherent risk of the investment. More conservative taxable money market funds predominantly invest in blue chip companies while the riskier funds venture into debts of lower-rated companies in pursuit of higher yields. The current annual yield for a taxable money market fund is approximately 0.70% to 0.80% annually, and is taxable at both the federal and state levels.

While some of the cash management instruments described above are designed to maintain a stable value or protect principal, all investments in securities, even U.S. treasuries, are subject to market fluctuations and carry a risk of investment loss. Every investor needs to determine and balance risk tolerance against both pre-tax and after-tax cash flow requirements. It is also important to remember that cash allocations are generally geared toward capital preservation and serve as the lowest risk component in the portfolio. That being the case, it may be more prudent to sacrifice a marginal amount of yield to provide peace of mind, especially in these troubled times.