How Do CDs Compare to Money Market Funds? - dummies

How Do CDs Compare to Money Market Funds?

By Russell Wild

All bonds are fixed-income investments, but not all fixed-income investments are bonds. Anything that yields steady, predictable interest can qualify as fixed income. That includes not only bonds but also CDs, money market accounts, and a few other not-as-common investments. Any and all of these may serve as sources of cash, either to boost a pre-retirement portfolio or to help mine cash from a post-retirement portfolio.

Certificates of deposit (CDs)

As predictable as the Arizona sunrise, CDs, like zero-coupon bonds, offer your principal back with interest after a specified time frame (usually in increments of three months) for up to five years in the future. Like savings bank accounts, CDs are almost all guaranteed by the Federal Deposit Insurance Corporation (FDIC), a government-sponsored agency, for amounts up to $250,000.

Interest rates offered tend to increase with the amount of time you’re willing to tie your money up. (If the bank will give you, say, 1.5 percent interest for six months, you can often get 1.75 percent for 12 months.) Take your money out before the maturity of the CD, and you pay a fine, the severity of which depends on the particular issuer.

Because nearly all CDs are federally insured, the security of your principal is on par with Treasury bonds. Interest rates vary and may be higher or lower than you can get on a Treasury bond of the same maturity. (Check and your local newspaper for the highest CD rates available.)

FDIC-insured Internet banking accounts, which tend to pay higher rates of interest than the corner bank, are also often on a par with one-year to two-year CDs. Often the three investments — CDs, short-term Treasuries, and Internet banking accounts — hug very closely to the same (modest) interest rate. If all three are equal, the CD, a favorite with retirees everywhere, should be your last choice. Here are two key reasons:

  • The CD requires you to tie your money up; the FDIC-insured Internet bank account does not.

  • The CD, as well as the bank account, generates fully taxable income; the Treasury bond or bond fund income is federally taxable but exempt from state tax.

Although there can be blips in time when CDs are great deals, by and large, CDs are vastly oversold. If you’re going to settle for a modest interest rate, you generally don’t need to have your money be held captive. Some banks of late have been offering more flexible step-up CDs that allow for interest rates to float upward; these are worth some consideration if the initial rate is competitive.

Compared to bonds: Most bonds provide higher long-term returns than CDs and tend to be more liquid (meaning you can cash out more easily). However, only Treasury bonds carry the same U.S. government guarantee that a CD has.

Money market funds

Money market funds are mutual funds that invest in very short-term debt instruments (such as Treasury bills, CDs, and bank notes) and provide (but do not guarantee) a stable price with a very modest return. Money market funds are not guaranteed by the federal government, as are most CDs and savings bank accounts, but they’re generally quite safe due to the quality of their investments and the short-term maturities.

At rare times, when long-term lending pays no more than short-term lending, money market funds can offer a yield competitive with or exceeding, short-term bond funds. (Short-term means that the bonds held by the fund generally mature in one to three years.)

But at most times, a money market fund doesn’t pay as much as bond funds. Some money market funds, however, may offer yields as high as you can get on any CD.

Money market funds are often used as the cash or sweep positions at most brokerage houses. Be aware that when you open an account at a brokerage house, the default, if you fail to specify which sweep account you want, may be a very low-yielding money market fund. And simply for the asking, you may have your money moved to a higher-yielding money market fund.

But you need to ask: “What are my sweep account options?” Some money market accounts, which hold short-term municipal bonds, offer tax-free interest, but the interest rate is usually less than the taxable money market accounts and, therefore, usually makes sense only for those in the higher tax brackets.

In 2008, Charles Schwab offered a short-term bond fund to its customers as a sweep option — sort of like a juiced-up money market. As it turned out, Schwab’s YieldPlus fund managers were squeezing that extra juice from some risky mortgage bonds, which wound up defaulting during the mortgage crisis. Schwab investors, who thought their money was safe, lost a bundle.

The SEC brought suit against Schwab, and three years later, investors recouped some, but not all, of their savings. Moving forward, brokerage houses will be much more careful about what funds they present as “stable” reservoirs of cash and what funds they offer as sweep options.

However, just in case you come across something that looks like a money market fund but is offering to pay considerably higher rates than all the others, make sure to read the prospectus carefully.

To date, only two real money market funds “broke the buck” — returning less principal to shareholders than they invested. In both cases, the principal lost was only about 1 percent (a penny on each dollar invested). And the regulations in place today are a bit tougher than they once were, making such a “break” less likely.

Compared to bonds: Expect most bonds and bond funds to provide higher long-term returns than money market funds. Money market funds, however, offer greater liquidity and (at least historically) a very high degree of safety.