If you are looking for a place to invest on a short term basis, how do you find the investment that is best for you?
In making your choice, there are three factors you need to weigh:
- Interest Rate
- and Safety of Principal
If Safety Is Important To You
If safety is more important than the amount you can earn on your money, you might put your money in an account at a financial institution that is insured by Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA).
A savings or money-market account at a bank or credit union will allow you instant access to your money. If you are willing to tie your money up for three months to a year, you can purchase a certificate of deposit which may earn a higher rate of interest. Generally, only the first $250,000 you invest will be insured.
Liquidity Plus A Higher Yield
If you are looking for liquidity plus a slightly higher yield than you can get at your bank or credit union, there are other money-market funds that might meet your needs.
Money-market funds are a particular type of mutual fund that is required by law to invest in low-risk, short term securities. Money-market shares can be bought or sold at any time. They often come with check-writing privileges. Money market funds try to keep their net asset value at a constant $1.00 a share so that only the yield goes up and down. They are generally successful at this. However, money market funds are not guaranteed by any agency.
For more information, see: U.S. Securities and Exchange Commission - Money Market Funds
Look Out for Lookalikes
There are other short term investments out there that are sometimes called money-market funds but are not subject to the same requirements as true money-market mutual funds.
Typically, these investments are not registered with the U.S. Securities and Exchange Commission (SEC). They are intended only for sophisticated investors or institutions. They often require large minimum investments. They pay higher rates than true money market funds but also have a higher risk of loss of principal or of liquidity.
Short Term Bond Funds
If you are looking for liquidity plus a greater yield than that offered by a money market fund, a short term bond fund may meet your needs.
A bond fund pools money from many investors to buy individual bonds that meet the fund's investment objective. Each bond fund is professionally managed, and is categorized based on the type of bonds in which it invests. A typical short term bond fund invests in bonds that will mature in two years or less.
While a short term bond offers a higher potential yield than a money market fund, it also carries more risk. When you own a bond or note from a credit-worthy issuer yourself, you will eventually get the principal and interest rate you contracted for if you hold the bond or note until it is due. Investing in a bond fund does not work the same way.
If more investors are taking money out of the fund than are putting money in, the fund managers may have to sell bonds in the fund even if it is not a good time to do so. The net asset value (NAV) of a share in a short term bond fund can fluctuate depending on the value of the bonds owned by the fund. Shares in short term bond funds tend to fluctuate less than shares in long term bond funds but even in a short term bond fund there is no guarantee that you will get back at least the amount of money you put into the fund.
Bond funds are subject to interest rate risk which is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates go up and down. Bond funds are also subject to credit risk which is the risk that the bond issuer may default on its obligation to pay the bondholders. They are subject to prepayment risk which is the risk that the issuers of the bonds owned by a fund will prepay them at a time when interest rates have declined.
For more information, see: Securities and Exchange Commission - Bond Funds.
Auction Rate Securities
Some investors who were looking for short-term investments bought auction-rate securities thinking that they could get a higher yield and still have liquidity. The yields on auction rate securities are set at weekly or monthly auctions. Until recently, few of these auctions failed. When auctions fail, investors’ accounts may be frozen even though an auction failure is not a default on the underlying bonds.
The Financial Industry Regulatory Authority (FINRA) has good information on what happens when auctions fail.