For the past several years, ultra-short bond funds have served as a higher-yielding alternative to money market mutual funds, but the gap in returns has rapidly been closing.
With taxable money funds offering yields averaging about 3.4 percent, according to the Money Fund Report, savers and investors who want to keep some liquid cash are enjoying better returns than they've seen in a long time. The current average is the highest it's been since July 2001, when it stood at 3.5 percent.
Short and ultra-short bond funds are still yielding a little more, but their advantage as a place to invest cash has definitely narrowed from the days when they delivered twice the returns of money market funds, as they did from 2002 to 2004. A quick glance at Fidelity's offerings shows the company's cash reserve fund (FDRXX) yielding 3.72 percent, while Fidelity Ultra-Short Bond (FUSFX) yields 4.02 percent and Fidelity Short-Term Bond (FSHBX) delivers 4.29 percent. Both have below-average expenses, an important factor in investments with low returns.
What you decide to do with your cash depends on when you plan to use it, said Scott Berry, an analyst with Morningstar Inc. With the yield landscape changing so rapidly, it makes sense to evaluate all alternatives. Money market funds hold great appeal because they offer increasingly attractive yields with little to no risk to principal. But if you don't plan to touch your cash for at least a couple of years, or if you need a place to stash an emergency fund that you hope to never tap, ultra-short funds still make good sense.
"If you look at the performance of money market funds versus ultra-shorts, ultra-shorts have really held up well," Berry said. "They've done what they were designed to do: They've preserved principal and provided more yield than the money market. And even though the gap has narrowed, they're still yielding more . . . and over time, that little bit can add up to a lot."
What doesn't make sense these days when it comes to fixed-income investing is taking on added risk with longer durations. Strange things are afoot in the bond universe when two-year Treasurys and five-year Treasurys deliver almost the same yield -- not much above the yields on six-month Treasurys.
Normally, investors expect higher yields for committing their money over longer periods, but the market is spooked by questions about the economy, inflation and possible changes in the policies of the Federal Reserve after Chairman Alan Greenspan retires early next year. This has resulted in a flattening of the yield curve, which some observers believe will eventually invert -- meaning shorter-term Treasurys will start to yield more than those with longer durations. Some market watchers say this would signal an economic downturn, but others argue that the economy is doing just fine.
The market is still absorbing the last hike in short-term interest rates, issued Nov. 1, and anticipating the next one, expected when the Fed meets Dec. 13. This very likely will push average money market rates close to or past 4 percent, said Peter Crane, managing editor of iMoneyNet, which publishes the Money Fund Report, which has tracked money market funds since 1975. What remains to be seen is how much closer yields will edge toward 5 percent, something cash investors haven't seen since 1999 and 2000.
"The old saw is the Fed hikes until something breaks," Crane said. "Cash has been the place to be, and it likely will be the place to be over the turn into 2006, but then the question is: Will the Fed be done raising rates at the end of January? Nobody is really sure what's going to happen."
If yields continue to move higher in 2006, chances are that more long-term money will move into the money market, which already holds about $2 trillion. That would continue a trend already in progress -- this past week alone, $13.19 billion poured into money market funds, according to iMoneyNet.
If you're looking for a new money market fund, shop carefully and pay close attention to time frame when comparing yields. With rates rising sometimes three times a quarter, money market yields can easily surge by a full percentage point. In weeks when the Fed meets, bank rates may tick up by a quarter of a percentage point and yields on money market funds might jump by 10 to 15 basis points. "It's all good news for savers," Crane said. "I've been trying to paraphrase Mark Twain's quote about the weather in New England: If you don't like the rates on your savings, wait a week."
Some money funds are already paying close to 4 percent. The top-yielding money market fund last week, according the Money Fund Report, was PayPal Money Market Fund (PAPXX), with a seven-day simple yield of 3.99 percent. Among the giant retail money market funds, Vanguard Prime Money Market Fund (VMMXX) was yielding 3.78 percent, while Fidelity Money Market Fund (SPRXX) offered 3.71 percent. It's easy to get caught up in the quest for the most competitive yields, but don't allow yourself to get hypnotized by it. Stay appropriately diversified, always make sure your investment matches your purpose, and resist the urge to time the market. Chances are you'll get it wrong.
"Money funds look very good at the moment, but you don't want to move everything into cash and at some point next year, when the rate hikes are over and the Fed starts cutting, find you've missed your chance to lock in higher long-term rates," Crane said.