When investing your hard-earned money, there is often a trade-off between return and volatility. Low-volatility assets – like bonds and money market funds – offer modest returns compared to investments like stocks or cryptocurrencies, where the price can fluctuate significantly.
Both types of investments, however, have a place in a diversified portfolio. Since the Fed has raised its benchmark rate significantly over the past year and a half, cash equivalents like certificates of deposit (CDs) and fixed income investments like bonds offer higher interest rates, making them more attractive to investors.
These investments offer varying amounts of liquidity – some require you to lock up your money for longer periods, while others do not. While these investments are currently lucrative, there are pros and cons to hiding money in them.
High yield savings accounts
High yield savings accounts are deposit accounts that offer more annual percentage yield (APY) than traditional savings accounts. These accounts are considered risk-free – but only if you choose to FDIC or NCUA-insured bank or credit union and maintain your balance below $250,000 per depositor per bank threshold.
The APY on high-yield savings accounts fluctuates with the Fed’s benchmark rate – when the Fed raises that rate, the APY usually rises and vice versa.
Advice: online banks they usually provide higher rates than physical banks.
Some banks may limit you to six monthly withdrawals when you want to access your cash. However, during the pandemic, the Federal Reserve waived the six-withdrawal-a-month rule, so you can use your money as needed.
And don’t be surprised when you get tax forms from your bank regarding your savings accounts: Interest earned on savings accounts is taxable, so you’ll have to pay income tax on your earnings.
Certificates of Deposit (CD) and Share Certificates
Like high-yield savings accounts, CDs or share certificates are a type of deposit account offered by banks and credit unions that are covered by FDIC or NCUA insurance.
These accounts typically offer a higher APY than high-yield savings accounts because they require you to deposit a fixed amount of money over a fixed term. The terms can vary from a few months to many years.
If you use your money early, you will generally pay penalty for early withdrawal worth several months of interest or more – be sure to do your research as longer term CDs may have higher penalties.
Although CDs are low-risk investments, they are subject to reinvestment risk, or the risk of reinvesting the money at a lower interest rate after your CD matures.
“We’re seeing attractive yields on three-, six-, 12-month CDs, but the risk is that in six or 12 months, when you have to reinvest those maturing proceeds if the Fed cuts rates, you may be reinvesting at a lower yield,” Collin says. Martin, Director, Fixed Income Strategist at Schwab.
To reduce this risk, consider creating CD ladderan investment strategy where you buy CDs with incredible maturities. This strategy allows you to take advantage of the higher rates offered on longer-term CDs while giving you access to cash at regular intervals.
Learn more about CDs:
Money market accounts
Money market accounts are similar to checking and savings accounts – they usually offer a higher APY of current accounts and easier access to cash than savings accounts. And because they are considered deposit accounts, they are covered by FDIC or NCUA insurance.
Like savings accounts, APYs on money market accounts are variable, usually changing with the federal funds rate. You may need to maintain a minimum balance to take advantage of a money market account. Otherwise, you may have to pay a monthly maintenance fee.
Some money market accounts also have check-writing privileges and a debit card linked to the account, so it’s a great place to park short-term savings.
Treasury securities
Treasury securities are debt obligations issued by the US government, so they are a (mostly) risk-free investment.
When you buy a Treasury, you are lending money to the government, which it then uses to finance its spending. You tie up your money for a set period, and the government gives you semi-annual interest payments plus the principal (or the amount you originally invested) when the bond matures.
There are many types of treasury – with terms of four weeks if you buy a Treasury bill up to 30 years if you opt for a government bond. Although you can sell Treasuries before they mature, they are sensitive to interest rate risk, meaning their price fluctuates with interest rate changes.
You can imagine the interest rate risk like this: you buy a connection with an interest rate of 3%, and next year the market rate on bonds is increased to 5%. When you try to sell your 3% bond, investors prefer the 5% one. The price of your 3% bond falls because it is less profitable than the 5% bond, and you lose money when you sell it.
You can benefit from buying government bonds because they offer unique tax benefits: Treasuries are exempt from state and local taxes, although they are subject to federal tax.
Series I bonds
Unlike the vault, Series I bonds they offer monthly interest payments and an interest rate that changes with inflation. It’s a solid investment option when prices are high, but not as solid a choice when inflation is falling and rates are weak.
The interest rate on I bonds is a combination of a fixed rate and an inflation rate that is set every six months.
Series I bonds have a maturity of 30 years, but you can cash them in sooner if you’ve held them for at least a year. However, this could mean a loss in interest payments. If you cash in the bond before the five years are up, you’ll miss out on three months of interest.
Because they’re issued by the Treasury Department, they’re risk-free investments, and you get tax breaks—you’ll have to pay federal taxes on them, but they’re exempt from state and local taxes.
Municipal bonds
Municipal bonds, or munis, are issued by state, city and local governments. When you invest in munis, your money is used to finance projects such as highways or schools. Like government bonds, the duration of munis varies from one year to more than a decade.
One of the main advantages of investing in municipal bonds is that they are exempt from federal taxes. Depending on whether you live in the state where they are issued, munis may also be exempt from state and local taxes. Because of their tax benefits, munis typically offer lower interest rates than other types of bonds, such as corporate bonds.
One of the downsides of investing in munis is that they are subject to liquidity risk, which is when it is difficult to sell or trade the security. It may be challenging to sell munis because the market for selling them is usually small, so they are not a good investment option if you need quick access to cash.
Like all bonds, munis are also subject to interest rate risk.
Corporate bonds
Companies issue corporate bonds to raise capital. Like other bonds, investors receive regular interest and principal payments after the bond matures.
These bonds are riskier than those issued by the federal government because the US government is unlikely to go bankrupt. Some agencies, such as Moody’s, are responsible for rating bonds based on their level of risk – with riskier bonds having higher yields.
Because corporate bonds are rated based on the company’s ability to pay, they are subject to default risk, which is the risk that the company will default or fail to pay its interest or principal.
Corporate bonds are subject to liquidity and interest rate risk like other fixed income securities. Their price can fluctuate with interest rate changes, and they can be challenging to trade and sell.
Money market funds
Money market funds are low-risk mutual funds invested in safe short-term assets such as government securities, CDs and municipal bonds. Because these funds are invested in short-term assets, they typically follow short-term interest rates, which fluctuate with changes in the Fed’s benchmark rate.
Unlike money market accountsmoney market funds are not FDIC insured – although they are considered relatively safe and you are unlikely to lose money investing in them.
You can invest in a money market fund through a brokerage account and your money will be readily available, making it a solid place to park money for a down payment or emergency fund.
Dividend shares
If you invest in dividend stocks, you get a share of the equity in the company and profits in the form of dividends. Dividends are earnings that companies pay out to shareholders quarterly, semi-annually or annually.
In general, well-established companies, known as value companies, pay dividends because they don’t need to reinvest their money for growth, according to Scott Sturgeon, CFP and founder of Oread Wealth Partners.
“As an incentive to shareholders, [value companies] issue dividends or periodic payments to a shareholder. This is similar to interest [payments] with the bond,” says Sturgeon. “Because these companies have been around for a long time or have a recognizable name, it could be seen as a little more conservative.”
However, unlike the interest payments you receive when you buy a Treasury security, dividends are not guaranteed. During financial turmoil, companies may reduce or completely cut their dividend payouts.
Instead of investing in individual company dividend stocks, you may want to minimize your risk by investing in exchange-traded funds (ETFs) or mutual funds that pay dividends. In this way, you spread the risk by investing in several companies at the same time.
In terms of paying taxes, dividends are taxed either at your ordinary income tax rate or at your capital gains rate.
To take away
Some cash equivalents – such as money market accounts – and fixed income securities are offering incredible returns because of the Fed’s rate hikes. While these investments can yield generous returns, those returns can fluctuate with changes in the Fed’s benchmark rate, making many of these investments subject to reinvestment risk.
“We’re trying to get [clients] that I’m not just sitting in cash now. We know that’s attractive, but when you think about it from a long-term standpoint, we encourage them to think about alternatives, so they’re not so dependent on what the Fed does or doesn’t do in the next few years,” Martin says.
Fixed income and cash can help reduce volatility and preserve capital in your investment portfolio, but putting your money into them could undermine your long-term financial goals. Instead of chasing high returns, you should focus on creating a portfolio—made up of stocks, bonds, and cash—that matches your liquidity needs, risk tolerance, and investment horizon.
