How to Profit as Yields Jump on Cash Accounts

More than 40 members of Congress wrote to Federal Reserve Board Chairman Alan Greenspan on Tuesday, advising him to stop raising short-term interest rates.

They’re forgetting that some people have waited a long time for this.

After five years of loose money (though it may not have felt all that loose), the economy is growing at a healthy pace and the Fed is tightening credit accordingly--quite a natural event, most economists agree.

And while most of the news stories since the first Fed interest rate boost Feb. 4 have focused on the negative aspects of higher rates, there are some clear winners here: Anyone who keeps money in short-term “cash” accounts, for example. That would include conservative savers, as well as the many smart investors who use a cash cushion as a buffer against turmoil in stocks and bonds.

So let’s say you’re trying to squeeze the maximum return out of your short-term cash today. What are the best options? Here are details on some common cash instruments.

* Money market mutual funds. These funds typically own very short-term corporate debt, government securities and bank CDs, and for that reason they are the easiest way to ride rising short-term interest rates. As they continually turn over their investments, they’re buying new paper at higher yields, so you earn more.

Money funds also are extremely safe; barring some catastrophe, your principal value stays constant at $1 a share, so many investors use the funds as substitutes for federally insured bank accounts. (The funds aren’t insured.)

Since Feb. 4, the Federal Reserve has raised its benchmark short-term interest rate from 3% to 3.75%. As other short yields have followed that rate higher, the average annualized yield on taxable money funds has risen from 2.71% to 3.08%, according to fund tracker IBC/Donoghue Inc. in Ashland, Mass.

At the same time, the funds have been shortening their investment maturities so they’re turning money over faster--the logical thing to do when the Fed is boosting rates. The average money fund maturity was 61 days on Feb. 4; now it’s 46 days. The upshot is that fund yields have further to climb, as they replace investments more rapidly at today’s higher rates.

Walter Frank, chief investment officer at IBC/Donoghue, figures that if the Fed raises its benchmark market rate to 4% soon as expected, money fund yields will level off at about 3.3% to 3.5% by summer. Fund management fees account for the difference between market rates and what the funds actually pay you.

One other option, if you’re in a high tax bracket: tax-free money funds, which invest in short-term municipal paper issued by states and cities. But tax-free yields can be more volatile: The average fund yields 1.81% currently, which is actually lower than the 1.86% average yield of Feb. 4.

* Bank CDs. Yields on certificates of deposit typically rise more slowly than money fund yields when the Fed is tightening credit, as banks try to keep their costs down for as long as possible. Still, CD rates are definitely in an up trend now, according to Robert Heady, publisher of Bank Rate Monitor newsletter in North Palm Beach, Fla.

One-year CDs now yield an average 3.34% nationwide, up from 3.03% on Feb. 4, Heady says. If you shop around, you can earn more. Bank of America had a one-day promotion last week, offering 5% yields on nine-month CDs.

But Heady suggests that most savers stay short. “A three-month CD is as long as I’d go now,” he says. The reason: He expects short-term interest rates to continue rising slowly through 1994 and perhaps into 1995 as the economy grows. If you keep your cash rolling over in three-month CDs (which average about 2.7% now nationwide), you’ll ride the tide higher, he says. It’s just too early to lock up cash in longer CDs, he argues.

* U.S. Treasury bills. If you feel a strong need to go “long” and you have at least $10,000 in cash, buy T-bills. Their yields are far above those of bank CDs: 4.40% now on a six-month T-bill versus 2.97% on the average six-month bank CD, for example. And, unlike CDs, T-bill interest is exempt from state tax--a big lure in high-tax California. You can buy three- or six-month T-bills direct from the Fed weekly. (Call (213) 624-7398 for order forms.) One-year T-bills are sold monthly. Many banks will also buy bills for you, for a fee.

More for Your Cash

Here’s how average yields on some common short-term savings vehicles have changed since Feb. 4, when the Federal Reserve Board began to tighten credit for the first time in five years.

Annualized yield Instrument Feb. 4 Now Taxable money funds 2.71% 3.08% Tax-free money funds 1.86 1.81 Bank money market accounts 2.30 2.33 6-month bank CD 2.75 2.97 1-year bank CD 3.04 3.34 3-month Treasury bill 3.28 3.98 6-month Treasury bill 3.47 4.40 1-year Treasury bill 3.83 4.88

Money fund yields are seven-day compound yields. CD yields are averages of the 100 largest banks and S&Ls; in key markets.

Source: IBC/Donoghue’s; Bank Rate Monitor