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Emergency fund investing

Dear Dr. Don:
I have about $15,000 as an emergency fund. My bank's money market account does not pay much interest. I am thinking about investing this in an ultra-short, short-term or intermediate bond fund. Is this a good idea?

Or should I go for a money market fund? I am looking for liquidity, while getting a little better interest than I would with CDs or a bank's money market accounts.
Kevin Cache

Dear Kevin,
An emergency fund is an important part of personal financial planning; congratulations on having yours in place. One of the frustrations with keeping the money in liquid investments is the lower yield on short-term investments. Ideally you won't ever need this money, so keeping it liquid seems like an expensive proposition.

There are a couple of approaches to minimize the loss of interest income on the emergency fund. One is to invest it in longer-term securities and accept some risk if you need to cash in. For example, you could invest in a five-year CD and accept the interest penalty if you had to cash in.

You're picking up more interest, but risk paying a penalty. Unlike investing in bonds, you aren't facing price risk if interest rates go higher. Non-negotiable FDIC-insured CDs don't face price risk, just early withdrawal penalties.

Penalties for early withdrawal vary by bank, so make sure you know the early withdrawal penalties for the CD you invest in before you decide on this strategy. This Bankrate feature discusses early withdrawal penalties in greater depth.

Alternately, you could invest in a laddered CD portfolio where you have a CD rolling off every six months.

Bond mutual funds are another alternative. You can choose the average maturity, credit risk and even investing in tax-free municipal bond funds. I don't think they're as good a choice for your emergency fund because the investment decisions and capital gains management are left to the mutual fund manager.

You could be taking on more price risk than you envisioned, if interest rates trend higher. (When interest rates go up, bond prices go down.) Bond funds often aren't very tax efficient, creating tax obligations that are outside your control.

Ultra-short and short-term bond funds have less price risk than an intermediate term bond fund because their short-term holdings aren't as volatile. An ultra-short fund will have an average maturity of about six months. Stay away from bond funds that invest in non-investment grade bonds because of the credit (default) risk.

-- Updated: Dec. 7, 2006

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