||Ask Dr. Don
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.
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,