Short-term investments are vehicles that we use when we need the money to be safe because we are going to be using it soon. For example, we are setting aside our financial aid for living expenses for the coming semester. We are building a down payment fund for a car or house. Hence, we often say that a short-term investment is a place to park your money. We don’t want the value to decrease. We don’t want to lose the money. We want the money to be there when we need it. For this reason, short-term investments are typically guaranteed or pretty darned close. Short-term investments are also very liquid; we can get our money very quickly, usually within a day. Some even allow us to write a check. These are the advantages and benefits of short-term investments.
What are the disadvantages of short-term investments? As we have seen, the returns from short-term investments are very low. Low risk? Low return! In fact, for many years since the 2008 Global Financial Crisis, many short-term investments were paying almost nothing. Short-term interest rates started to climb very slowly starting in 2015 and were actually approaching respectable amounts in 2019 as the economy was finally shaking off the lingering effects of the economic devastation a decade earlier. And then Covid hit and short-term rates again fell close to zero. (Darned, stupid microbe!) In 2022, the Federal Reserve Bank started raising short-term rates and as of this writing, they are once again paying typical returns of between 1% to 4%.
Stated Rate of Interest versus Discount Basis
As we explore the various short-term investment alternatives, we will see that some offer the stated rate of interest method of paying interest and some offer the discount basis method. The stated rate of interest is the method that we are already familiar with if we have ever opened a savings account. The bank will tell us that they will pay us 1% on our money. If we deposit $100, after one year, we will earn 1% of $100 or $1. This is very straightforward.
The discount basis is a bit trickier. This method of earning interest entails purchasing the security at a price below its redemption value, also known as the par value, maturity value, or face value. The difference between the purchase price and redemption value is the interest earned. Since the securities are negotiable, the value of the investment grows as it approaches its maturity date. We say the interest “accrues” on the short-term investment. On the date of maturity, the current owner of the security receives the maturity value. An example: You purchase a security now for $4,800 that will be redeemed for $5,000 in ten months. Your interest would be $200. If you were to sell the security in five months, ‒ one half the time until maturity ‒ the value would likely have accrued to $4,900. One half of the $200 would be $100 of interest and that would be added to the price of the security.
Risks of Short-Term Investments
“Risks of short-term investments!? Wait a minute! You told me that these investments were risk-free!” Yes, short-term investments are risk-free regarding the loss of principal, also known as the risk of default. We are not going to lose our money. However, there are other risks when investing. There is the risk that we may lose purchasing power. Over time, short-term investments have barely kept up with inflation. Currently, they are losing to inflation. There is also the risk of lost opportunity cost. Opportunity cost is an annoyingly nebulous concept that you would discuss in detail in your ECON 101 class. It is real, though. Whenever we make a choice, we must think about the opportunities that we forego by making that choice. What else could we have done with our money? If we choose short-term investments for money that we won’t need for the long term, we will almost certainly have done much worse than by carefully researching and choosing prudent, long-term investments. You first saw this in the graphics discussing the returns of stocks versus bonds versus short-term investments in the previous presentation and we will see examples of this throughout the semester.
Sadly, you will sometimes come across individuals who have placed all their investable savings into short-term “cash” investments. This is usually money that they are saving for long-term goals such as retirement. These people need to take Introduction to Investments! In time, Dear Readers, you will be the Investment Gurus for your friends, family, and colleagues. You will gently but firmly educate and guide them in choosing prudent, long-term oriented investments that will clobber the meager returns they were getting from their short-term investments. You will speak with authority. They will thank you profusely. We will be proud of you. You may even decide that you want to pursue a career in the investment services industry.
That’s just the first of many pep talks. Stay tuned for more because the industry needs you. For now, it is time to run through the various types of short-term investments. Don’t do this before bedtime … unless you are prone to insomnia. Again, these choices are not very exciting but then again, they are not meant to be exciting. They are meant to ensure safety of principal. With short-term money, boring is good.
Demand Deposit Accounts
Demand deposit accounts are offered by commercial banks and credit unions. The name comes from the fact that depositors can withdraw the funds at any time; the funds are available upon demand. However, there are sometimes certain restrictions upon this ability such as when you want to withdraw a large amount of money in cash. Demand deposit accounts at banks and credit unions have a very important benefit: They are typically guaranteed by an agency of the Federal government. You may have heard of the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). Your money is safe. Practically all banks and credit unions belong to these entities. If you are unsure if your bank or credit union belongs, just ask. For each account at each bank or credit union, you are currently insured up to $250,000. If you have more than $250,000, you can simply distribute that amount into separate banks or credit unions. (If you have more than $250,000 and this is not short-term money, you need to take Introduction to Investments and learn where to allocate your investable assets more effectively and prudently for long-term growth of capital and income. My apologies if you have heard this before but it bears repeating. The opportunity cost of keeping long-term money in short-term investments is very high.)
Common examples of demand deposit accounts are checking accounts and savings accounts at banks and share-draft accounts and share accounts at credit unions. Those of you who use credit unions have probably never heard of share-draft or share accounts. That is because no one at the credit union uses those terms; they just use the same terms that the banks use, checking and savings. Even though there are legal differences, as far as we retail customers are concerned, there are no differences. They both work the same way. For many years, the regulators would not allow checking accounts to pay interest. For this reason, banks and credit unions offered Negotiable Order of Withdrawal (NOW) accounts. Again, no one called them that; they just called them checking accounts that paid interest. That restriction was removed in 2010 so now, NOW accounts are not as popular as they once were. (And no, that is not a double word typo.) Lastly, banks and credit unions can offer money market accounts, also known as money market demand accounts. Money market accounts typically pay more than checking and savings accounts. These accounts are very similar to the money market mutual funds. In fact, the banks and credit unions simply copied the concept from the mutual fund industry. The main difference between money market accounts and money market mutual funds is that the money market accounts at banks and credit unions have the same $250,000 guarantee as other demand deposit accounts; money market mutual funds at mutual fund companies do not have this guarantee. We will discuss money market mutual funds a bit later on.
We mentioned that there may be some restrictions on your ability to withdraw your funds upon demand. An example of this would be if you were to walk into your neighborhood bank and ask to withdraw the entire $187,000 in your savings account ‒ in cash! The bank would most likely ask you to wait until tomorrow because they simply don’t keep that much cash on hand. (There’s over $250,000 in the ATM next door, though. Shows you how safe and secure the banks believe their ATMs are.) The bank would also contact the FBI and report a “suspicious transaction.” This is courtesy of the Patriot Act, hurried through Congress within a month after the attacks on the World Trade Towers on September 11th, 2001. Some people will tell you that a deposit or withdrawal of $5,000 or $10,000 constitutes a “suspicious transaction.” This is not true. There is no specific dollar amount. The bank or credit union must determine what is a “suspicious transaction,” depending upon the circumstances. Kinda’ creepy, huh? The FBI will check up on you for carrying around your own money.
Certificates of Deposits (CDs)
Certificates of Deposits (CDs) are also offered by banks and credit unions and have the same guarantees as demand deposit accounts, namely the $250,000 deposit insurance guarantee. Unlike demand deposit accounts, though, CDs are time deposit accounts, also known as term deposits. They have a maturity date. You agree to keep your money on deposit for a certain time, anywhere from seven days to several years. Typically, the longer the time period, the higher the rate of interest a CD investor will receive. The rate of return is usually better than demand deposit accounts such as savings accounts or money market accounts. What are the disadvantages? If you need to withdraw the money before the maturity date, there will be a penalty. Also, your rate of return is fixed and typically does not change. If interest rates rise, your CD will not rise with them. For this reason, many banks and credit unions offer Bump-Up CDs. If interest rates have risen, the Bump-Up CD allows an investor to “bump up” their initial interest to the current interest rate. CD investors need to be aware of the rollover or renewal provision of some CDs. Some banks or credit unions will automatically renew your CD at the end of the time period. The bank or credit union is required to notify you of the upcoming renewal. You typically have the option of requesting that the funds be automatically deposited into your savings or checking account. It definitely pays to shop around for the best CD interest rates. CD rates vary widely and as long as your bank or credit union belongs to the FDIC or NCUA, you can do business with institutions in the United States and its territories and have the same guarantee of principal.
Some brokerage firms and some banks offer Brokered CDs. The brokerage firm has invested a great deal of money with a bank and that generates more income than a typical retail investor will receive. The brokerage firm then can offer these higher rates to their customers. Also, unlike typical CDs, they can be bought and sold on the open market as are other securities. An investor does not have to wait until the maturity to receive their principal. The downside is that Brokered CDs are not FDIC-insured. For this reason, it is important that Brokered CD investors deal with a reputable brokerage firm.
Money Market Mutual Funds
Money market mutual funds are short-term investments offered by mutual fund companies. Recall that a mutual fund is a company that pools the capital of a large number of investors. A money market mutual fund uses their investors’ capital to invest exclusively in short-term securities. They are also known as mutual money funds, or more simply and more typically, money markets. Because they are offered by mutual fund companies and not banks or credit unions, they do not have the same protections that money market accounts at banks and credit unions have, namely the $250,000 principal protection guarantee. However, in practice, they are considered essentially as safe as their counterparts at banks and credit unions. Why? There is a long history of the government and the industry doing their parts to ensure that money market clients do not lose a penny! In practice, that is exactly what can happen. Your money market fund can “break the buck.” When that happens, the whole world sits up and takes notice. Just type “breaking the buck” into any Internet search engine and see how many millions of results you get. There are tremendous forces allied against any money market ever breaking the buck.
Money markets are very versatile and popular. Virtually every mutual fund company offers one or sometimes several different types of money market funds. Many money markets allow you to write checks, although in practice, most investors simply link their money market funds to their checking and savings accounts at their banks and credit unions and electronically withdraw funds as needed. Money markets allow you to easily exchange funds to and from your stock and bond mutual funds at your mutual fund company. Money market funds typically pay interest rates higher than checking and savings accounts and only a bit less than CDs. However, unlike CDs, the interest rates on money market funds change daily. Therefore, if interest rates rise, your money market interest rate will rise with them. There is much to like about money market mutual funds.
Series EE, HH, and I Savings Bonds
Savings bonds are short-term investments that are offered by the United States Treasury. The Treasury currently offers both Series EE and Series I savings bonds. The Series HH bonds were discontinued in 2004 and will all mature and disappear by 2024. The Series EE savings bonds use the discount basis of accruing interest. In other words, for example, you might buy a Series EE savings bond for $50 and it will pay its maturity value of $100 in 20 years. Currently, though, Series EE bonds purchased online electronically are purchased at face value and earn interest in the stated rate of interest manner. Savings bonds are exempt from state income taxes. (We will discuss more about the tax relationship of the Federal government and the state and local governments later in the class.) If you use the proceeds from your savings bond for qualified higher education expenses, then the interest is also exempt from Federal income taxes.
The “I” in Series I savings bonds stands for Inflation. Series I bonds were introduced in 1998 to cater to those investors worried about inflation. Like Series EE savings bonds, Series I bonds do come with a fixed rate of return but that rate of return is far less than other types of short-term investments, including Series EE bonds. Instead, Series I bonds add an inflation-adjusted interest amount every six months that varies with the rate of inflation. Hence, Series I bonds are guaranteed to keep pace with inflation. Series I bonds became immensely popular with the investing public in 2022 when inflation spiked.
The yearly purchase limits are currently $10,000 for Series EE bonds Series I bonds. For decades, United States savings bonds were popular gifts to newborns. Grandparents and aunts and uncles would buy them at their local bank for the new arrival to the family. The bonds would be tucked away in a drawer somewhere and promptly forgotten about until the parents passed away and the adult kids and adult grandkids were tasked with clearing everything out of the house. The Treasury has done away with paper savings bonds for Series EE bonds and are phasing out paper savings bonds for Series I bonds. All bonds are now available for purchase and safekeeping at www.TreasuryDirect.gov. TreasuryDirect.gov is the subject of one of your chapter 1 assignments.
Treasury Bills are short-term investments that are also offered by the United States Treasury. They are often informally referred to as T-Bills. T-Bills all have maturities that are less than one year. The most typical periods are one month (4-week), three months (13-week), and six months (26-week), although two months (8-week) and twelve months (52-week) are also available. Treasury Bills are often considered the safest of all investments. As mentioned, when the investment community wants to report the current risk-free rate of return, they often use the rate for three-month Treasury Bills.
T-Bills are usually sold in $1,000 increments and use the discount basis method for paying interest. For example, you may purchase a six-month $1,000 Treasury Bill for $990 that will mature at $1,000. The $10 difference would be your interest received. Along the way to the six-month maturity date, because these are securities, you could sell your Treasury Bill, again, at a discount to the $1,000 maturity value. As the date of maturity becomes nearer, your Treasury Bill will increase in value. The price would depend upon the prevailing market rates but any volatility would be close to zero. Remember, Treasury Bills are very safe. At the date of maturity, the T-Bill would be redeemed for the full $1,000 face value.
Like the Series EE and I savings bonds, interest from Treasury Bonds is tax-exempt at the state and local level. Unlike Series EE and I savings, though, the interest is not tax-exempt if used for the qualified higher education expenses.
Also like the Series EE and I savings bonds, Treasury Bills are available for purchase at www.TreasuryDirect.gov. TreasuryDirect.gov offers you and me, the common retail investors, the same prices as the big boys and girls on Wall Street. It is a very well done website and, as mentioned, the subject of one of your chapter 1 assignments. The Mexican government has a website very similar to TreasuryDirect.gov. It is called Cetes Directo. Your Humble Author had the good fortune to meet the project manager during a visit to Mexico City. He acknowledged that they essentially copied TreasuryDirect.gov verbatim. We love to complain when our government screws up. Hence, we should rightly praise them when they do something well. Thanks, United States Treasury!
Commercial Paper and Banker’s Acceptance Notes
Commercial paper investments are short-term, unsecured promissory notes (IOUs) issued by corporations with very high credit standings. Corporations typically use these vehicles when they need a very short-term loan for payroll or maybe for the large purchase of goods in anticipation of a coming increase in business activity such as major retailers preparing for the Christmas surge. Instead of going to a bank, the corporation can go to the investment community and get a much better rate than the bank would charge. Like Treasury Bills, commercial paper investments use the discount basis and are sold at a discount to their maturity face value and have short-term maturity periods of one, three, six, and nine months. Unlike Treasury Bills, commercial paper investments are typically denominated in $100,000 increments and commercial paper dealers normally want you to buy many of them at one time. Hence, they are usually purchased by financial institutions such as life insurance companies and pension funds. Money market mutual funds are also eager buyers of commercial paper. You and I are not going to buy commercial paper except indirectly through our investments in money markets. (If you are indeed in the market for commercial paper and can afford multiples of $100,000 denominations, then congratulations but I have a sneaking suspicion that you have your own private broker.)
Banker’s acceptance notes are cousins to commercial paper investments. They, too, are sold at a discount, are tradable securities, are typically denominated in $100,000 increments, and mature quickly. Banker’s acceptance notes usually mature in 90 days but the maturity date can be up to 180 days. They are often used to facilitate domestic and international trade for companies that do not have the prestige and financial wherewithal to issue their own commercial paper in the marketplace. The company petitions the bank for help and the bank issues the acceptance notes which the company can sell on the open market. The company then uses the proceeds to facilitate the trade. The company must pay the bank the face value at the maturity date so that ultimate holders of the notes can be paid. If the company defaults, the bank must make good on the notes.
By keeping the maturity periods to less than one year, the issuers of corporate paper and banker’s acceptance notes are not required to register their securities with the Securities and Exchange Commission. This helps keep the fees associated with these short-term investments low.
Which Short-Term Investment Is Right for Me?
We have explored the various short-term investment alternatives. It is time for you to answer the question, “Which short-term investment is right for me?” Everyone is different and so that question can only be answered by you. Here are our observations: Because of their costs, commercial paper and banker’s acceptance notes are usually only suitable for institutional investors. Savings bonds used to make cute gifts for newborns in paper form but now that they are all electronic, will the proud new parents still coo and awe when the card is opened only to say that their newborn’s savings bond is safely tucked away at TreasuryDirect.gov? Many savvy investors purchase Treasury Bills directly from the Treasury at www.TreasuryDirect.gov. Certificates of Deposit are okay for those that are sure that they will not need the money until maturity. In our opinion, their flexibility and ease of use make money market mutual funds and money market deposit accounts the preferred choice of most investors, especially since every bank, credit union, brokerage firm, and mutual fund company offers them. Sadly, many uninformed savers still use a passbook savings account from a bank or credit union. (They have not taken this course yet. Such a shame!)
Emergency Fund Debate
If you watch the financial media outlets and listen to any of the talking heads with their perfect hair and immaculate dental implants, they will vehemently insist that you have an emergency fund. An emergency fund is essentially a liquid, short-term investment in which you place three, six, nine, or even twelve or more months of income. This is a self-insurance program in case of losing your source of income or another costly emergency arises. Some experts, most notably David Chilton, author of The Wealthy Barber, do not agree with this strategy. Of course, no one is advocating that you have $17.87 in your rainy day savings account; some substantial amount socked away for that rainy day is obviously a great benefit to your financial well-being. However, for those still working, assuming you have a marketable skill that would allow you to find gainful employment in a reasonable amount of time, there can be better uses for that money. You can use those funds to pay down expensive debt or increase your monthly retirement or investment contributions. There are exceptions, though. Anyone who works in sales or has their own business or works in a seasonal industry definitely needs a substantial emergency fund. We would be remiss if we forgot to ask one last thing: You do have proper and adequate insurance, yes? For more discussion about emergency funds and insurance and all topics related to personal finance, please consider taking BUS-121, Principles of Money Management, at Southwestern Community College.
The Federal Reserve Bank and Short-Term Interest Rates
We mentioned that short-term interest rates change over time. You may be wondering, “Well, who sets these short-term interest rates?” For a more thorough investigation, you will want to take an Introduction to Economics class. The short answer, though, is that the Federal Reserve Bank is responsible for setting short-term interest rates in the United States. It is often referred to as the Fed. They are the nation’s central bank and are often called the bankers’ bank since the banks of our nation use the Fed as their bank. The Fed has major two objectives. They are charged with keeping the nation’s economy at full employment while at the same time, keeping inflation under control. These two objectives are often at odds with one another. The Fed has tremendous power and the Chairperson of the Federal Reserve Bank is often called, “the second most powerful person in the nation.” (The most powerful person, of course, is the President, who is the Commander in Chief of the military.) The Federal Reserve Bank was designed to be independent and not subject to political pressures. That does not stop politicians and other high-profile individuals from criticizing their actions. In fact, many vocal critics even claim that the Federal Reserve Bank is unconstitutional. Suffice to say that no system we humans have ever created is perfect, and that includes the Fed. However, for over 100 years, the Fed has bumbled along and sometimes has executed brilliantly and sometimes has failed miserably. We don’t call Economics the “Dismal Science” for nothing, Dear Students.