Mutual funds, stocks, bonds, or other investment media can be considered after one’s financial situation is stable and potential losses can be absorbed. Investments in equities and bonds have a high degree of risk and should not be the initial component of early stage financial planning. The most important component in personal financial planning is LIQUIDITY. One definition of Liquidity refers to the ability to convert to cash quickly. For example, cash, savings and checking accounts have instant utility and liquidity.
Savings and checking accounts are the primary step in any financial planning program. These everyday savings instruments are well known and are not presented in this analysis. Money market funds and money market mutual funds have many of the same features and advantages as savings and checking accounts; many of these funds incorporate the advantages of savings/checking accounts. These money market funds provide convenient and instant liquidity because checks may be issued from the holder’s account.
Certificates of Deposit (CDs) are another principal building block in any investment portfolio. Certificates of deposits are “time deposits” and therefore do not offer instant liquidity as explained later. CDs are debt instruments issued by banks and other types of financial institutions for purchase by savers and investors. Every individual’s risk tolerance is different; fundamental attention must be given to one’s personal risk tolerance, outstanding debt, savings targets, and personal level of income and living expenses.
Personal factors affecting investment decisions are age, particular goals, and the risk that one can financially and emotionally accept. Diversification is a basic investment principle; don’t put an entire savings amount into just one basket (defined as one type of investment).
The following money instruments will be discussed: · Money Market Funds · Money Market Mutual Funds · Certificates of Deposit
MONEY MARKET FUNDS
Money market funds offer many of the same benefits as certificates of deposit with the added features of liquidity and a checking account. Technically speaking, a money market is a mutual fund that attempts to keep its share price at a constant $1. Professional money managers will take the funds deposited in the money market and invest them in government T-bills, savings bonds, certificates of deposit, and other safe and conservative financial instruments. This income is then paid out to the owners of the money market.
Investors can open a money market account at almost any financial institutions. The investor (depositor) generally receives a checkbook. Pros: Depositing money in a money market is as easy as depositing cash into a saving or checking account. Cash is immediately available for personal use or alternative investments. Cons: Some financial institutions place a limit on the number of checks that can be drawn against the account in any given month. The rate of interest is often directly proportional to the investor's level of deposited assets, not to a maturity date, as is the case with certificates of deposit. Hence, money markets may be disproportionately beneficial to wealthier investors.
The Verdict For those who need access to their capital, money markets are an alternative. Many brokerage houses automatically sweep their customer’s uninvested cash into money markets to earn interest between investments. This is the ideal solution because the funds can be used immediately to purchase stocks, bonds, or mutual funds.
SEC: New rules for money market funds Improved liquidity · Daily requirement: At least 10 percent of assets must be in cash, U.S. Treasury securities or securities that convert to cash within one day. · Weekly requirement: At least 30 percent of assets must be in cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, or securities that convert to cash within one week.
Higher credit quality · Funds are restricted from investing more than 3% of their assets in lower quality, second-tier securities. · Funds are restricted from investing more than one-half of one percent of assets in second-tier securities issued by any single issuer. · Funds are restricted from buying second-tier securities that mature in more than 45 days.
Shorter maturity limits · The maximum "weighted average life" maturity of a fund's portfolio is restricted to 120 days. The "weighted average maturity" of a fund's portfolio is restricted to 60 days.
Redemptions · Funds are required to hold sufficiently liquid securities to meet foreseeable redemptions and they must anticipate the likelihood of large redemptions. · A money market fund's board of directors is permitted to suspend redemptions if a fund is about to "break the buck" (drop below $1) and decides to liquidate the fund.
MONEY MARKET MUTUAL FUNDS The term money market account is confusing because it may refer to a money market mutual fund, a bank money market deposit account or a brokerage sweep free credit balance. Banks in the United States offer savings and money market deposit accounts; but these are not money market mutual funds. Money market bank accounts generally may offer higher yields but usually require higher minimum balances and limited transactions in the account.
Money Market Mutual Fund Defined
A money market mutual fund is a special type of mutual fund with investor protective provisions mandated by federal government law. Money market funds can be purchased directly from a mutual fund, bank, or stockbroker. The Securities and Exchange Commission’s (SEC) stipulates that money market funds may only invest in low-risk securities such as certificates of deposit, commercial paper, repurchase agreements, short-term bonds or other money funds.
The Securities and Exchange Commission’s Investment Company Act of 1940 regulates money market funds in the United States. Rule 2a-7 of the Act restricts investments by money market funds. These investments by a fund must meet standards according to quality, maturity and diversity. Under this act, a money market fund mainly buys the highest rated debt, which matures in less than 13 months. The portfolio must maintain a Weighted Average Maturity (WAM) of 90 days or less and not invest more than 5% in any one issuer, except for government securities and repurchase agreements.
Net Asset Value per Share
Money market funds aim to keep their net asset value (NAV) at a constant $1.00 per share. NAV is computed as follows:
Total assets minus total liabilities Number of outstanding shares
For example, if a mutual fund has an NAV of $100 million and investors own 10,000,000 shares of the fund; NAV per share is $10. The NAV changes daily because of the fund’s performance in the stocks and other investments held by the fund; the NAV is also affected by the number of shares held by its investors, (which usually changes daily due to purchase and redemption of the fund). Most mutual funds publish their NAVs per share in daily newspapers.
By maintaining a constant $1.00 share price, only the percentage yield of the fund is affected; the yield goes up and down as its share price changes. However, it is possible for a money market’s NAV per share to fall below $1.00 if its investments perform poorly. While investor losses in money market instruments are rare, they are possible.
Market for Money Market Mutual Funds
Mutual fund companies, banks, insurance companies, and other financial institutions offer money market mutual funds. There is a ready market for these money market mutual funds. The investor may tender the mutual fund shares directly to the mutual fund or a broker. Registered open-end companies may not suspend the right of redemption and must pay redemption proceeds within seven days, except in certain emergencies or for such other periods as the Commission may by order permit for the protection of security holders of the company. Generally, money market mutual funds do not incur any sales charge or redemption charge.
Insurance for Money Market Mutual Funds
Unlike a “money market deposit account” at a bank or insured CDs, money market funds have traditionally not been federally insured. On September 19, 2008, the U.S. Treasury Department announced the establishment of a temporary guarantee program for the U.S. money market mutual fund industry.
U.S. Department of the Treasury’s Temporary Guarantee Program for Money Market Funds
The U.S. Department of the Treasury now has a Temporary Guarantee Program for Money Market Funds. This Program must be applied for by the money market fund; it is not directly available to shareholders. The Guarantee Program provides coverage to shareholders for amounts that they held in participating money market funds as of the close of business on September 19, 2008. Under the Guarantee Program, the Treasury Department will guarantee the share price of participating money market funds that seek to maintain a stable net asset value of $1.00 per share, subject to certain conditions and limitations.
Current yields of money market funds · The average money-market fund yields about only 0.06% and the bank’s average money-market account yield is about 0.15% as of Monday, according to the Federal Deposit Insurance Corp. (Savings and interest checking accounts averaged 0.10% and 0.07%, respectively.) Bank money-market accounts do have an advantage, while money funds pay a market rate based on securities yields, banks can pay "artificial rates based on funding needs and competitive factors," says Robert Deutsch, managing director at JP Morgan Asset Management, the largest U.S. money-fund manager.
· The online service Bankrate.com said its recent survey of 100 leading commercial banks, savings and loan associations and savings banks in the nation's 10 largest markets showed the annual percentage yield available on money market accounts was at 0.12 percent.
Certificates of Deposit
CDs are basically similar to savings accounts but they are not identical. A CD is purchased for a stated amount and no additional deposits are permitted. CDs do not allow immediate access to the “invested” funds because there is an agreement between the Investor (saver) and the bank (issuer) to keep those specific funds on deposit for a stated period of time. During this period of time, a CD earns a stated interest, usually expressed as a percentage. CDs usually offer a better interest rate than savings or checking accounts featuring an immediate withdrawal feature. CDs are risk-free because they are generally insured by the FDIC for banks or by the National Credit Union Administration for credit unions. However, there is a limit on the amount of insurance coverage limit; this limit is explained later in this analysis.
Banks, savings associations, brokers and other depository institutions offer Certificates of Deposits to individuals, corporations, and other organizations as a more sophisticated savings tool. A certificate of deposit is a promissory note issued by a bank and payable to the owner of the CD. A CD is a time deposit; therefore CD holders are restricted from withdrawing funds on demand. Banks are not required to redeem the CD prior to the CD’s maturity. Those banks that allow early redemption may charge a penalty for this privilege. There are no regulations governing the penalty that a bank may charge. At the maturity date, the CD may be redeemed together; the holder receiving the principal plus accrued interest. Banks generally will allow an early withdrawal of CDs without penalty due to death or adjudication of incompetence of the depositor.
When advertising the rate on a CD, the following must be disclosed: · The “Annual Percentage Yield” or “APY” (The interest rate that will be earned) · Maturity date or period · Minimum deposit required · Any penalty for early withdrawal · Right of the issuer to redeem or “call” the CD
Payment of Interest
Generally, the interest (and principle) is paid when the CD matures. However, it may be possible to have the interest periodically mailed as a check or transferred into a checking or savings account; some institutions allow the customer to select this option only at the time the CD is opened.
Federal Insurance on CDs
Most banks are members of the FDIC (Federal Deposit Insurance Corporation), a government agency that insures bank deposits. For example, all the deposits (savings accounts, checking accounts, CDs) an individual owns at one bank in his/her names are insured up to a total of $100,000. There is additional $100,000 coverage for all deposits owned at one bank in joint accounts. IRAs and certain retirement accounts are insured up to $250,000 per owner. These coverage limitations only apply for insured accounts at one bank. Insurable funds at different banks are treated independently by the FDIC and enjoy new separate coverage. For example, a person with accounts at two separate banks (not merely branches of the same bank) will have such funds insured for those deposits, up to the FDIC insurance limit for each account.
The FDIC’s brochure Your Insured Deposit explains deposit insurance coverage in more detail. It is available at no charge from the FDIC, many banks and securities brokers. Contact information for the FDIC: by mail (550 17th Street, N.W., Washington, DC 20429) or by phone (800-276-6003). Also complete information is available on the FDIC website at: http://www.fdic.gov/
Features of CDs
CDs are issued with different maturity periods, for example, the time period could be for three months, one year, or five years. CDs are issued at a $1,000 minimum and multiple investment denominations that allow for flexible investing objectives. CDs may vary with the following features: · Interest Rate · Redemption · Brokered CDs · Liquidity · Early withdrawal
CD Interest Rates Computation Differences
In addition to interest rates and maturity terms, CDs may have different provisions for computation of interest rates. The following types of CDs have particular interest computations or considerations: · Fixed Rate CD · Zero Coupon CD · Variable Rate CDs 1. Floating Rate 2. Step 3. Contingent Rate · Bump-Up CD
Fixed Rate CDs Fixed rate certificates of deposit earn a stated interest rate for the entire term of the CD determined at the time of deposit (purchase of CD). The rate along with the annual percentage yield (APY) will appear on the deposit receipt. At maturity the holder receives the principal plus the earned interest.
Zero Coupon CDs Zero Coupon CDs are sold at a discount to their face amount and pay the entire face amount at maturity. For example, For example a $1,000 face value CD is issued for $950 and the face value of $1,000 is later received at its maturity date; therefore the interest received is $50.
Variable Rate CDs Variable rate CDs have an interest rate that may vary during the life of the CD. There are several types of variable rate CDs, namely: · Floating Rate · Step Rate · Contingent Rate
Floating Rate CDs offer rates that change at predetermined times during the CD’s term using some type of financial references such as the prime rate or some financial other index. As these indices decline or rise, the rate on these CDs will likewise follow.
Step Rate CDs change to a pre-determined rate at pre-determined times. The interest rate is fixed for a period of time and then “step up” or “step down” to another fixed rate. The steps may occur more than once before the CD matures.
Contingent Rate CDs feature a rate that is determined by the outcome of some event or the performance of a financial index. Based on a predetermined index, CDs might pay interest linked to the stock market. The interest rate increases when the stock market rises; conversely, the rate decreases if the market falls. It is possible not to receive interest based on a poor performance of the stock market. Usually a contingent rate CD has an APY of 0% because the interest rate cannot be determined at the time the CD is purchased.
Bump-Up CDs A “Bump-Up CD” gives the owner an option to increase the interest rate one time during the term of the CD. Upon request from the owner of the CD, the bank will “bump up” the interest rate on the certificate of deposit to a higher rate as that being offered by the issuing bank on a comparable term CD. The original maturity date of the CD id not affected.
Redemption Features Some CDs may be redeemed by the issuer at its sole discretion and are known as “callable CDs.” On pre-determined dates, the issuer can cancel the CD by redeeming it at its face value plus any accrued interest. It is common for the issuer to redeem a CD when interest rates have declined below the original stated rate on the CD because the bank can issue new CDs at a lower rate. Banks and brokers must disclose that a CD is callable.
Brokered CDs Brokered CDs are CDs issued by banks but generally sold by a securities broker registered with the SEC (Securities and Exchange Commission). Brokers not registered with the SEC might be subject to little regulation or not be subject to any regulation. Brokered CDs are obligations of the issuing bank, not the broker who “sells” the CD. Brokered CDs usually have the same features as that of “bank sold” CDs. Brokered CDs can also have FDIC insurance as if the CD was purchased directly from a bank.
A broker usually sells CDs without a fee because the broker receives compensation from the issuing bank. The securities broker will provide a trade confirmation that describes the terms of the CD plus a disclosure document describing the CD holder’s, deposit insurance coverage and other important items. Brokerage CDs are portable and can be transferred from one brokerage firm to another (or a bank) giving its owner more investment and planning flexibility.
Brokers provide similar services provided by a bank. For example, (1) the broker will hold the CD as the buyer’s custodian and keep a record; (2) the broker will provide taxable interest for income tax purposes. However, unlike banks, securities brokers are required to provide the estimated market value of the CD as of the date of the customer’s account statement. This information is provided should the CD holder decide to liquidate the CD prior to its maturity.
Liquidity Liquidity is an important difference between CDs purchased from a bank (Bank CD) and a broker (brokered CDs). A bank CD is generally held till maturity or redeemed prior to that date incurring a possible penalty charge. Brokerage CDs may be traded (sold) in a secondary market (at market prevailing prices) making it possible to get cash before the CD’s maturity date. If a CD is sold prior to maturity, its redemption value will be affected based on its size, time remaining before maturity and the current level of interest rates. The secondary market’s prevailing prices may be more or less than the original investment. This “sale” is not an early withdrawal, but it will generally incur a broker’s selling commission.
CD Ladders The typical CD investment is in a single CD with a specified rate and maturity date. However, large sums to be invested require a different investment strategy. With a CD Ladder Strategy, a lump sum of money is invested over different CDs with different maturity dates. No one can predict with certainty the future of interest rates. The earnings might not be as much by locking in a specific rate for a stated long-term in a single CD; however, the earnings could be greater using the ladder theory should interest rates rise in the interim.
For example, an individual, company, or association has $200,000 to deposit for a 5-year period. Using the CD Ladder Strategy, this $200,000 is fully invested by purchasing the following batch of CDs with one transaction:
1-year CD for $40,000 2-year CD for $40,000 3-year CD for $40,000 4-year CD for $40,000 5-year CD for $40,000
As each CD comes up for renewal, a new 5-Year CD is purchased, locking in the best interest rate at the time. If interest rates go up, the money from the matured CD is invested in a better yielding new 5 year CD. If interest rates go down, 80% had been invested at higher rates. Every 12 months, new funds become available for investing.
Interest on CDs is Taxable
Generally interest on CDs (not in a qualified retirement type account) is taxable when it is received. However, you may be required to pay taxes annually on zero-coupon CDs even though these CDs do not pay interest annually under the tax provision called “Original Issue Discount.” Taxes are deferred on IRA or other retirement accounts; however the income tax is due when distributions are made from those accounts.
Questions to Ask before Buying a CD
Will the funds be needed before the CD matures? Does the CD meet stated investment objectives? Are total deposits at the bank plus amount of CDs within the FDIC’s coverage limit? What is the APY, maturity, early withdrawal, Call features? What are the terms offered on other available CDs? Is the interest paid at maturity or periodically throughout CD’s term? What is the tax consequence associated with the CD?
Current CD Rates CD rates are still falling because of the slack demand for business and consumer loans, Banks profit on the spread between the interest rate they charge customers to borrow money and the interest rate they pay to account holders for deposits, known as the net interest margin.
Certificates of deposit currently offer low yields of about 1% or less. 5-year CDs might yield slightly more. CD yields will continue to fall this year as they did in 2012, says Dan Geller, executive vice president for Market Rates Insight, a banking industry research firm based in San Anselmo, Calif.