Five Short-Term Investments that offer Safety of Principal and a Reasonable Return

This manifesto is all about the best short-term investments for those with money to invest that need their principal back in less than three years. I get the question occasionally, "“What is a good short-term investment to put money into that I will need in a year or two?”

The actual questions will vary in content. Some people ask about a specific amount, such as “…a good short-term investment for $50k”, or a shorter time-frame as in "What investments are good if I need the money in six months?”

To answer the question as completely as possible, I put together this resource for finding, understanding, and investing in short-term investments that meet the following criteria:

1. Any time we are talking about investing in the short-term, the investment must have safety of principal over all other things. If you will need the money soon, the stock market is out of the question because of its volatility. Even if you have a year or two, the market can correct and stay depressed and when your two years are up and you need the money, you will have lost some principal.

2. The most preferable short-term investments will be those where your principal is guaranteed or insured, or backed by the safest government repayment promise. Anything other than a guaranteed or insured investment is too risky for short-term investing.

3. The short-term investment should be liquid or have a maturity equal to when you will need the money. You should not buy illiquid investments that are difficult to unwind, or that mature after you need the money.

4. Anyone should be able to invest in them. If they are difficult to find or figure out, they are not right for most people.

With those requirements, our universe of possible short-term investments is limited to a select few. First, I will lay out the list of possibilities, and then we will deep dive into each one. As I see it, one can safely choose from the following short-term investments, presented in order of simple to complex:

1. FDIC insured interest bearing checking or savings accounts.

2. FDIC insured Certificates of Deposit at Tier 1 banks with maturities equal to your need or laddered.

3. U.S. Treasury Bills and Notes, and Floating Rate Notes with maturities equal to your need.

4. FDIC insured money market accounts

5. Agency bills and notes with explicit U.S. government guarantees with maturities equal to your need.

Each of these types of short-term investments are discussed in detail to give you a foundation on which to build your knowledge of them. Lets start with ranking them by relative interest rate from smallest rate to largest rate:

  • U.S. Treasury Notes and Bills -the least risk and least interest rate
  • FDIC insured bank accounts and money market accounts
  • Certificates of Deposit - higher interest than checking, savings, or money market accounts
  • Agency Bonds - highest interest on this list, and more risks than most of the others

And now for some details about each of these types of investments.

FDIC-insured bank accounts preserve capital but offer low interest rates as short-term investments

Most accounts, such as your checking account and savings account at your local bank are insured by the Federal Deposit Insurance Corporation (FDIC) which is the U.S. corporation insuring deposits in the United States against bank failure. The FDIC was created in 1933 to maintain public confidence and encourage stability in the financial system through the promotion of sound banking practices.

FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC began operations in 1934, no depositor has ever lost a penny of FDIC-insured deposits.

The FDIC insures deposits according to the ownership category in which the funds are insured and how the accounts are titled. The standard deposit insurance coverage limit is $250,000 per depositor, per FDIC-insured bank, per ownership category.

As of 2017, at the time this article was written, FDIC deposit insurance covers the depositors of a failed FDIC-insured depository institution dollar-for-dollar, principal plus any interest accrued or due to the depositor, through the date of default, up to at least $250,000. For example, if a person had a CD account in her name alone with a principal balance of $195,000 and $3,000 in accrued interest, the full $198,000 would be insured, since principal plus interest did not exceed the $250,000 insurance limit for single ownership accounts.

FDIC insured accounts are usually the lowest-return short-term investments. In 2017 an account such as this offered a measly 1.05% return for an entire year invested.

Because pretty much anyone can open a bank account (you walk in to any bank and tell an employee that you want to open an interest bearing account), it is the easiest way to invest for the short-term, but offers the least interest and therefore the lowest return.

Tax implications of investing in FDIC-insured bank accounts

Interest received from bank accounts is taxable at your personal income tax rate. You will receive a 1099-INT from the bank after the end of the taxable year.

The risks of investing in FDIC insured bank accounts

· Anything over $250,000 per depositor is not insured

· Assumes that the U.S. Government remains solvent

Where to go for more information about FDIC insurance

You can follow this link to the FDIC.gov website to read more about FDIC insurance limitations and specifics

Certificate of Deposits offer better interest than bank accounts and can be short-term investments

A Certificate of Deposit (CD) is a step up from bank accounts in terms of interest paid to you. This investment is purchased through your bank, or through your broker, and you commit to leaving your money in the CD until it reaches maturity. You can select which maturity you want: anywhere from one month to five years!

Most CDs are insured by the FDIC just like bank accounts. This provides principal protection. There is no volatility with CDs as the maturity is fixed and you are locked in for the duration (most of the time).

Not all CD’s are the same. Here are some types of CDs you can choose.

There are a number of different types of CDs you can choose from

Traditional CD: You receive a fixed interest rate over a specific period of time. When that term ends, you can withdraw your money or roll it into another CD. Withdrawing before maturity can result in a hefty penalty.

Bump-Up CD: This kind of account allows you to swap your CD’s interest rate for a higher one if rates on new CDs of similar duration rise during your investment period. Most institutions that offer this type of CD let you bump up once during the term of your CD and keep the interest rate for the remainder of the original CDs term.

Liquid CD — This kind of account allows you to withdraw part of your deposit without paying a penalty. The interest rate on this CD usually is a little lower than others, but the rate is still higher than the rate in a money market account.

Zero-coupon CD — This kind of CD does not pay out annual interest, and instead re-invests the payments so you earn interest on a higher total deposit. The interest rate offered is slightly higher than other CDs, but you’ll owe taxes on the re-invested interest.

Callable CD — A bank that issues this kind of CD can recall it after a set period, returning your deposit plus any interest owed. Banks do this when interest rates fall significantly below the rate initially offered. To make this type of CD attractive, banks typically pay a higher interest rate. These accounts are typically offered through brokerages.

Brokered CD — This term refers to any CD offered by a brokerage. Brokerages have access to thousands of banks’ CD offerings, including online banks. Brokered CDs will generally carry a higher rate of interest from online and smaller banks because they’re competing nationally for depositors’ dollars. However, you’ll pay a fee to purchase the account.

Ladder CD maturities to provide cash periodically

You can ladder CD’s in such a way that you have a chunk of money available every month or every two months or however often you need it. For example, you can start by buying a three month, six month, nine month, and one year set of CDs. After three months, the first CD will mature and you can buy another one year CD with the proceeds. From then on, you will have a CD maturing every three months that you can either use elsewhere or buy another one year CD to keep the ladder going.

Once you get good with CD’s, you will find yourself hunting for the best CD rate you can find, even if it’s a bank you have never been a customer of before. Just be sure the CD is FDIC-insured and you will be fine.

Tax implications of investing in Certificates of Deposit

Interest received from certificates of deposit is taxable at your personal income tax rate. You will receive a 1099-INT from your bank after the end of the taxable year.

Risks of investing in Certificates of Deposit

· Anything over $250,000 per depositor is not insured

· Assumes that the U.S. Government remains solvent

· You may lose out on some interest if rates rise while you are locked in to a non-floating rate certificate of deposit

Where to invest in Certificates of Deposit

Your local bank will most likely offer CDs of varying interest rates and durations. Whatever bank you have a relationship should be the first place you shop for certificates of deposit. If you are willing to explore other offerings, you can check out the offerings at BankRate.com, a website that aggregates offers from various banks and lending sources. Your broker will mostly have offerings that you an invest in through your brokerage account.

U.S. Treasury notes and bills - held to maturity - preserve capital but pay the least interest

Debt issued by the United States government is backed by the full faith and credit of the taxpayers of the United States. This makes U.S. Government bonds more secure than corporate (private) bonds. Short-term bonds are less sensitive to interest rate fluctuations than intermediate-term bonds, but they pay less. At the time this manifesto was written in 2017, short-term government bonds do not pay much interest, but rates are rising and this will lift the yield on these debt instruments.

Bond prices will fluctuate with changing interest rates. Bond prices and yield move in opposite directions, so if you are holding a bond and interest rates rise, the bond price will fall.

With that in mind, my recommendation is to buy bonds that mature at the time you need the money in cash.  You will be holding the security to maturity, and, therefore fluctuations in price will not be a concern.

There are a wide range of maturities of U.S. issued debt. The difference between bills, notes and bonds are the lengths until maturity:

  • Treasury bills are issued for terms less than a year, with the shortest being 3 weeks and the longest being 52 weeks (one year). Bills don’t pay interest, they are sold at a discount from their face value to create the yield.
  • Treasury notes are issued for terms of 2, 3, 5, and 10 years. Notes pay interest every six months.
  • Treasury bonds are issued for terms of 30 years and pay interest every six months. They were reintroduced in February 2006.
  • Floating Rate Notes (FRNs) are bonds where the interest payments rise and fall based on discount rates for 13-week Treasury bills. FRNs are issued for a term of 2 years and pay interest quarterly.
  • Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of 5, 10, and 30 years.
  • I Savings Bonds are a low-risk savings product that earn interest while protecting you from inflation. Sold at face value. I Bonds are meant to be long-term investments. They continue to earn interest for up to 30 years. You can cash them in after one year. But if you cash them in before five years, you lose the last three months of interest. (If you cash in an I Bond after 18 months, you get the first 15 months of interest.)
  • EE and E Savings Bonds are a secure savings product that pay interest based on current market rates for up to 30 years.
U.S. Gov Security Maturities Interest Schedule Coupon
Treasury Bills 3 Weeks to 52 Weeks Sold at discount to face None
Treasury Notes 2, 3, 5, and 10 years Bi-annual (6 months) Fixed
Treasury Bonds 30 years Bi-annual (6 months) Fixed
Floating Rate Notes (FRNs) 2 years Quarterly (3 months) Variable
Treasury Inflation-Protected Securities (TIPS) 5, 10, and 30 years Bi-annual (6 months) Variable
I Savings Bonds 30 Years Bi-annual (6 months) Fixed + variable
EE and E Savings Bonds 1 Year to 30 Years* At redemption only Fixed

* Minimum of one year.

Given the range of maturities, you can easily create an investment plan for yourself to buy bills or notes that mature right when you need the money. If you find that you have more time before you need it, you can always wait for the bill or note to mature before buying into another bill or note.

Where to invest in U.S. government securities

You can buy these securities through your brokerage account, or you can buy direct from the U.S. Treasury at the accurately named TreasuryDirect.gov website.

Tax implications of investing in U.S. Government Securities

Interest earned on all U.S. Treasury securities, including treasury bills, is exempt from taxation at the state and local level but is fully taxable at the federal level. At the end of each year, owners of treasury bills should be sent a Form 1099-INT by the Treasury

The risks of investing in U.S. Government Securities

The risks of investing in U.S. Government Securities includes:

· The government defaulting on a payment

· The price of any held U.S. securities falling as interest rates rise (which is why you hold to maturity if you are a short-term investor)

Where to get more information about U.S. Government Securities

· TreasuryDirect.gov

Money Market Accounts may pay more interest than other bank accounts, but less than CDs

A Money Market Account (MMA) is a type of savings account that usually earns a higher amount of interest than a basic savings account. The minimum deposit and balance for this account is often considerably higher than the minimum balance of a basic savings account. They can range from $500-$50,000.

Money market accounts are insured by the U.S. government through the Federal Deposit Insurance Corporation (FDIC) under the same limitations described above.

When you deposit money into an MMA, it earns interest just like a regular savings account. You can open a MMA at your local bank. If you want to be more adventuresome, you can explore rates at other banks and if you find one that is much better, you can open an account with that bank.

The interest on an MMA is usually compounded on a daily or monthly basis and paid on a monthly or quarterly basis. MMA accounts are often subject to required withdrawal and transfer limitations. You will have to get these details from your bank.

Just like with any bank account, you can deposit money into an MMA any time and in any amount.

Do not confuse a money market account with a money market fund

Money market accounts are bank accounts that are FDIC insured. Money market funds are brokerage offered securities that are not FDIC insured and not suitable for short-term investing.

Tax implications of investing in money market accounts

Interest received from certificates of deposit is taxable at your personal income tax rate. You will receive a 1099-INT from your bank after the end of the taxable year.

Risks of investing in money market accounts

With recent improvements in regulation of money market accounts, many of the risks that caused one money market account to “break the buck” have been reduced.

Since money market accounts are FDIC insured, they have the same risks as any other FDIC insured account.

Find out more about the recent changes to money market regulations here.

Where to invest in money market accounts

You can check with your brokerage firm for access to money market accounts, or your local bank. You can also browse through a bunch of offerings from all kinds of banks by clicking the button below.


Agency bonds pay more interest have more risk than Certificates of Deposit

Agency debt also known as an Agency bond is a security, usually a bond, issued by a U.S. government-sponsored agency or federal budget agency. The offerings of these agencies may be backed by full faith and credit of the US government or may have an explicit guarantee by the US government.

The “agencies” that only have an explicit guarantee are typically private corporations referred to as “Government Sponsored Entities” or “GSEs.” These
GSEs hold government charters because their activities are deemed important to public policy.

Some examples of things that these GSE’s provide are:

· Home loans (Federal National Mortgage Association “Fannie Mae” and Federal Home Loan Mortgage Corporation “Freddie Mac”)

· Farm loans (Farm Credit System and Federal Agricultural Mortgage Corporation “Farmer Mac”)

· International trade financing

The difference between an agency backed by full faith and credit and one with only an implicit guarantee is negligible when it comes to the yield you will get as an investor. However, the yield on agency debt will be slightly higher than that on U.S. Treasury bills and notes accounting for the higher risk stemming from political risk that guarantees can be modified and the slightly less liquid nature of these agency instruments.

There may be differences in the tax rate you will pay at the state level on interest you receive from agency debt depending on which agency issued the instrument. In the case where you can choose an agency bond with no state tax incurred and the same yield as another agency bond where interest is state taxable, go with the no-state-tax bond if you will be holding it in a taxable brokerage account.

Most agency bonds pay a fixed rate of interest or fixed coupon rate semi-annually. Most agency bonds are non-callable or "bullet bonds."

Variable or floating coupon rate agency bonds are agency bonds that have interest rates that adjust periodically and are usually linked to an index such as U.S. Treasury bond yields or LIBOR according to a predetermined formula. There are usually limits on how much each can adjust.

Just like zero coupon treasuries or Treasury notes, some agencies are non-coupon discount notes and are issued at a discount to par value.

Investors should generally stay away from callable agency bonds with "step up" coupon rates. These are a type of callable agency bonds that have a pre-set coupon rate "step up" that provides for increases in interest rates or coupon rate as the bonds approach maturity.

We are trying to keep things simple, and “set up” callable agency bonds are not as easy to understand for the average investor.

Tax implications from investing in agency bonds

The interest from most but not all agency bond issues is exempt from state and local taxes and it is important for investors to understand the tax consequences of agency bonds;

Capital gains or losses when selling agency bonds are taxed at the same rates as stocks. Consult your financial advisor before determining whether agency bonds are a suitable investment for you.

Where to buy agency bonds

Agency bonds are traded on the secondary market and auctioned as new issues.

You can buy agency bonds through your brokerage. Just be aware that you are likely to incur fees or transaction costs. Most retail investors will need to call their broker to order individual bonds unless your brokerage platform includes a bond trading function that will allow you to search for agency bonds to research.

Agency bonds are not as liquid as U.S. Treasury securities

The agency bond market is considered relatively liquid, even for retail investors. Some of the agency bond issues may be considered illiquid and not suitable for most investors.

There may be investment minimums that may make buying and selling individual agency bonds less suitable to many individual investors.

Investors should be aware that the tax status of various agency bond issues varies depending on the agency issuer. As with any investment, it is important to understand the work of the agency or enterprise that is issuing the bonds and know the credit rating of the issue.

Tax implications of investing in agency bonds

The interest income on agency bonds generally is subject to federal and state taxes. Interest on certain agency bonds, including securities issued by the FHLB and FFCB, is exempt from state taxes. Agency bonds, when bought at a discount, may subject investors to capital gains taxes when they are sold or redeemed.

Risks of investing in agency bonds

· The price of any held agency securities falling as interest rates rise (which is why you hold to maturity if you are a short-term investor)

· Risk of Agency becoming insolvent

· Risk of any implicit guarantee being negated by regulatory action

Where to find more information on agency bonds

  • For more information and documentation for investors on Federal Farm Credit Banks Funding Corporation bond issuance programs, click here.
  • For more information and documentation for investors on Federal Home Loan Banks Office of Finance (FHLB) bond issuance programs, click here.
  • For more information and documentation for investors on Federal Home Loan Mortgage Corporation (FHLNC, also known as Freddie Mac) bond issuance programs, click here.
  • For more information and documentation for investors on Federal National Mortgage Association (FNMA, also known as Fannie Mae) bond issuance programs, click here.
  • For more information and documentation for investors on Government National Mortgage Association (GNMA, also known as Ginnie Mae) bond issuance programs, click here.
  • For more information and documentation for investors on Tennessee Valley Authority (TVA) bond issuance programs, click here.

Why you should NOT put short-term money into ETFs

Exchange Traded Funds are one of the most popular investment vehicles…for Wall Street. They get high fees for managing ETFs. That alone would be reason enough for me to avoid them, but I’ll go a bit further on this topic. ETF’s are not backed buy the full faith and credit of the U.S., whether explicit or implied. They are created by Wall Street. If an ETF fails, there is no backstop to get your money back.

It doesn't matter whether the ETF has U.S. Treasuries, agency bonds or anything else. ETFs are not suitable as short-term investments.

Short-term money should only go into securities where you are absolutely certain of safety of principal and a reasonable return. Period.

Conclusion

Short-term investments require safety of principal above all things and then a reasonable return. Anything else is not suitable for the short-term investor.

If you found this manifesto valuable, please leave a comment below

About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the “What Works In Investing?” podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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