Better-Yielding Alternatives to Money Markets

It’s drought time for money market funds. Average yields have evaporated to around 5.5%--a four-year nadir and one of the lowest levels on record. Rate-parched investors must be looking back at those 9% yields of two years ago and wondering whether there’s any relief in sight.

Near term, the answer may well be no. The Federal Reserve has been pushing short-term rates lower and probably won’t allow them to rise much until there’s proof the recession has ended.

Money funds still deserve a place in your portfolio as a safe haven against stock and bond market fluctuations. But assuming that rates stay near current levels, you might want to switch some cash into higher-returning alternatives.

The categories of bond funds described below can’t claim the same degree of price stability as money funds. But they do offer the potential for greater returns in an environment of stable interest rates for investors willing to assume additional volatility.

* Short-term bond funds. In terms of risk and return, these are near-cousins to money funds and are a logical choice for investors who can tolerate only a bit more heat. Short-term bond products hold debt coming due within one to three years--not enough time for interest rate fluctuations to wreak much havoc on the share price.

For example, a portfolio of Treasury bonds maturing in one to three years would likely rise or fall by only 2.5 cents on the dollar if interest rates changed by a full percentage point, says Thomas J. Steffanci, director of fixed-income funds for Fidelity Investments in Boston. (There would be virtually no impact on money funds, of course, since most hold debt maturing within three months.)

You can’t expect miracles with short-term bond funds. As a group, they returned only about 8% annually from 1986 through 1990, versus 7.1% for money funds. In 1987, a year of generally rising interest rates and falling bond prices, money funds actually fared better.

But at the moment, the short-term portfolios enjoy a yield advantage of about 2.5 percentage points--an unusually wide edge, says Steffanci. “Even if interest rates rise 1% from here, a fund that goes down 2% in price with an 8% yield would perform no worse than what an investor could get in a money fund now.” For that reason, he advises money-fund investors to move some cash into a short-term bond portfolio, even though he predicts that interest rates will rise gradually if the economy continues to firm.

- Intermediate-term bond funds. Because the so-called yield curve is steeply sloped at the moment, you can pick up a lot more interest income by investing in funds that hold bonds with more distant maturities.

Unfortunately, you also expose yourself to extra price volatility. An “intermediate” Treasury or corporate bond--one coming due within five years--can be expected to rise or fall about 3.5 cents on the dollar, assuming interest rates decrease or increase by one percentage point, says Steffanci. A fund holding long-term bonds, with maturities 10 to 30 years out, will move anywhere from 7 to 9.5 cents on the dollar.

Are higher yields worth the extra fluctuations? That’s for each person to decide. But Steffanci warns against making big changes in your fixed-income portfolio just to pick up a little extra income. “The great temptation is to seek that alternative with the greatest yield. That could be a mistake now,” he says, considering that rates have been falling for months and the recession is showing signs of ending.

Instead, he recommends moving only part of your money into more aggressive bond funds, possibly following a dollar-cost averaging strategy of monthly or quarterly investments. One possible choice: GNMA or Ginnie Mae funds, which hold mortgage securities that yield a bit more than Treasuries, even though they too are guaranteed against default by the federal government. GNMA portfolios returned about 8.3% annually on average from ’86 through ’90.

So far this year, the funds are enjoying brisk sales, about double what they were for the same period in 1990. However, that’s a worrisome sign; the last time GNMA-fund sales exploded was in 1986, and the following year the portfolios returned a scant 2%, including interest.

* Short-term global bond funds. Intuitively, these products make a lot of sense. They have leeway to invest in higher-yielding foreign bond markets. And by keeping maturities short, they can reduce volatility.

Unfortunately, they also face the danger posed by a rising dollar, which decreases the value of securities denominated in other currencies. Over the past four months, the dollar has appreciated around 20% against the German mark, French franc and British pound. Critics wonder how these relatively new funds will hold up during a prolonged period of dollar strength.

The funds contend that they can minimize currency risks by hedging, and so far that seems to be the case. The two largest portfolios, offered by Alliance Capital Management and Merrill Lynch, posted commendable returns of 4.8% and 3.4%, respectively, during the first five months of this year, according to Lipper Analytical Services.

Clearly, the short-term global bond products aren’t money market substitutes. But if these funds can continue to hold down volatility, they deserve consideration from risk-shy investors looking for more generous returns.

But if you’re unwilling to accept any of the share-price fluctuations that come with bond funds, look for money market portfolios that pay higher yields. William Donoghue, publisher of Donoghue’s Moneyletter in Holliston, Mass., likes funds that invest in Treasury bills and other short-term, government-backed debt. These funds can pay higher effective yields because the interest on the securities they hold avoids state (but not federal) income taxation.

Donoghue’s favorites include Fidelity Spartan U.S. Treasury Money Market Fund (800-544-8888; $20,000 minimum), Dreyfus 100% U.S. Treasury Money Market Fund (800-762-6620; $2,500), Strong U.S. Treasury Money Market Fund (800-368-3863; $1,000), Benham Government Agency Fund (800-472-2389; $1,000) and United Services Government Securities Savings Fund (800-873-8637; $1,000). All five offer current yields from 5.9% to 6.1%, which translate to tax-equivalent rates of 6.5% to 6.7% for Californians.