Cash Is Trash

Cash really is trash. The average taxable money-market fund yields 0.08%. The yield of the average tax-free money fund is 0.12%. Even a one-year bank CD will, on average, pay you less than 1.8%, according to Bankrate.com.

Once in a while, it pays to take a little risk with your "safe" money -- and this is such a time. I'm not talking about taking money you've put aside to buy a car in six months and dumping it into stocks or a high-yield bond fund. But investing that money carefully in the right short-term, high-quality bond fund -- or maybe even an intermediate-term bond fund -- makes a lot of sense.

Most investors should start -- and probably end -- their search for such a fund with Vanguard. That's because the Malvern, Pa., firm generally charges the lowest fees on most types of bond funds -- and because the firm is conservative to its core. Its bond managers seek out the highest-quality bonds and don't try to get cute.

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It's a mark of that conservatism that Fran Kinniry, of Vanguard's investment strategy group, considers my idea a bad one. He thinks investors should keep enough money to replace from six to 12 months' worth of income in nothing riskier than a money-market fund, even though Vanguard's flagship money fund, Prime Money Market (symbol VMMXX), yields a meager 0.20%. He doesn't think any money you expect to spend over the next year should be in anything riskier. "We are very risk-averse," he says.

I think Kinniry is too cautious. My favorite tax-free money-fund alternative is Vanguard Limited-Term Tax-Exempt (VMLTX). The fund yields 1.7%. That's equivalent to 2.4% for an investor in the 28% tax bracket and 2.6% for someone in the top 35% bracket. Its bonds have an average credit-quality rating of double-A and an average maturity of 2.7 years. Should yields rise by one percentage point on bonds with similar maturities, the fund's price would drop only 2.5%. Expenses are just 0.20% annually.

Last year, when most bonds suffered because of credit-quality concerns and lack of liquidity -- rather than rising interest rates, which generally cause bond prices to fall -- Limited-Term Tax-Exempt held up marvelously. From January 22, 2008, through last October 30, the period of maximum stress, the fund lost a paltry 0.3%.

What if you're in a low tax bracket or you're investing in a tax-deferred account, such as an IRA? Vanguard Short-Term Investment-Grade (VFSTX) is your ticket. It yields 3.1%. If yields on similar bonds rise by one percentage point, its price should decline about 2%, leaving the fund with a positive return of about 1%. Average credit quality is single-A. During last year's bond-market meltdown, this fund, which invests almost entirely in corporate bonds, fell 6.5% at its worst.

Willing to take on a little more risk? Consider Vanguard Tax-Exempt Intermediate Term (VWITX). It boasts average credit quality of double-A and charges just 0.20% annually. It yields 3.2%, which is equivalent to 4.4% and 4.9% for investors in the 28% and 35% tax brackets, respectively. It lost -4.3% during the 2008 setback. But it would lose about 6% if yields on similar bonds were to rise by one percentage point, so this fund is only for more risk-tolerant investors.

Vanguard has rules designed to restrict short-term trading of its bond funds. If you sell shares of a fund, you can't buy back into that fund within 60 days. So you can't use one of these funds as a checking account -- unless you invest all you plan to before you start writing checks.

Risks to consider. It's worthwhile to consider what happened in 2008 -- partly because it was so merciless with risk takers. From the January 22, 2008, bond-market peak to October 30, investment-grade corporate bond funds lost 7.9%, on average.

But many funds did much worse than that. Morningstar identified 120 ostensibly high-quality taxable bond funds with assets totaling $150 billion that lost more than 10% in 2008. It also found 137 municipal-bond funds with such losses. "We found levels of risk that, in some cases, we've rarely seen in open-end mutual funds before," bond analyst Eric Jacobson wrote. Some of these funds were supposed to be just one step from money-market funds in terms of safety.

Schwab YieldPlus Select is the poster child for that group. It invested heavily in asset-backed and mortgage-backed bonds. The fund plunged 35% last year and shed another 11% this year through August 21. Assets, which peaked at almost $14 billion, are now a paltry $220 million. A number of class-action suits have targeted Schwab.

The silver lining to 2008 is that bond funds received a real-life stress test -- at least in terms of credit risk. If a fund didn't implode in 2008 because of the credit quality of its bonds, odds are it never will. Interest-rate risk -- the risk a fund will decline in value as yields rise -- is another matter. Funds weren't tested for that last year. That's why I think you should stick to relatively short-term bonds, which are, by definition, at lower risk should interest rates spike upwards..

Once economic growth finally picks up steam, the U.S. will almost certainly see a rise in inflation -- and interest rates. In what looks like a successful effort to stave off a depression, the Federal Reserve and Congress have used a variety of measures to push the government's balance sheet more deeply into the red than it has ever been. But as growth picks up, inflation is almost guaranteed to return. Given the tremendous slack in the economy, however, I think that's the last thing to worry about right now.

But at some point, yields on money markets and other lower-risk options will become attractive again.

The phrase "cash is trash," incidentally, isn't an original. Elaine Garzarelli, who gained fame for predicting the 1987 stock-market crash, coined the term late in 1991 as the Fed was cutting short-term interest rates in response to the 1990-91 recession. It turned out to be good advice then, as stocks embarked on a nine-year period of superlative returns, and I think it’s good advice now.

Steven T. Goldberg (bio) is an investment adviser.