Articles from Business Library
Cash equivalents are shortterm, interest-earning instruments or investments with high liquidity (easily and quickly converted to cash) and high safety. In general, they earn more than a bank checking or passbook savings account, but with little additional risk.
Cash equivalents serve two basic purposes: as a place to store emergency funds to help meet living expenses in the event of a sudden drop in income or to pay for large, unexpected expenses such as a medical or legal bill; and as a parking place for investment money until one is ready to put it into more attractive assets such as stocks, real estate, or long-term bonds. If short-term interest rates are high, cash equivalents might be good investments themselves, but historically, most short-term investments barely keep ahead of inflation.
According to the Institute of Certified Financial Planners, the major cash-equivalent options are:
Money market mutual funds. These are not Federally guaranteed against loss of principal, but, because of their diversification, strict regulations, and investment in high-quality short-term debt, their risk is very low. Money market funds typically fall into two general categories--those that invest in high-quality commercial debt along with some government securities, and tax-exempt municipal bonds.
Bank money market accounts. These are Federally insured up to $100,000. They often require higher investment and have more withdrawal restrictions than non-bank money market mutual funds, and their interest rates tend to be a bit lower.
Treasury bills. Issued with three- or six-month maturities, T-bills are Federally guaranteed securities exempt from state and local income taxes. They carry some risk if sold before the maturity date in a rising interest-rate market. The biggest problem for smaller investors is that the minimum T-bill denomination is $10,000.
Certificates of deposit. CDs are Federally guaranteed (just make sure the issuing bank is FDIC insured). Three- to six-month CDs generally are considered the equivalent of cash, though a large portion of interest earnings usually is lost if they are cashed out early. Stagger the maturity dates if buying six-month CDs so a certificate is due soon at any given time.
Short-term bond funds. Not all financial advisors consider these cash equivalents. They are a little riskier than CDs, Treasury bills, and money markets, though they also provide a higher return. To be a good cash equivalent, the funds should invest in bonds with average maturities of no more than three months to a year.
It pays to shop around for cash equivalents since rates vary. Newspapers and personal finance magazines typically publish top rates. Those in a high income-tax bracket should compare tax-exempt funds with taxable funds. If the difference is narrow, the tax-exempt may provide a substantially higher yield.
Articles from Business Library