As their name implies, cash investments are easily redeemable with small, if any, penalties for withdrawal. Examples of cash investments include money market funds, bank accounts and certificates of deposit (CDs).
Investors benefit from the low-risk yield and high liquidity of cash investments. The downsides to cash investments are the low interest rate and the fact that a favorable interest rate can only be locked in temporarily due to the short periods of time that the interest rate is locked in.
Certificates of Deposit
Traditional CDs are savings certificates that pay a fixed interest rate until they reach maturity. Most are issued by banks and have a somewhat higher interest rate than savings accounts. CDs are very flexible in that they can be issued in any denomination and have a range of maturities. The most common maturities are three months and six months. When the CD reaches maturity, the holder receives the principal invested plus all interest earned while the CD matured. CDs are very safe investments and are insured by the federal government up to $100,000. One downside to CDs is that there is a penalty associated with removing funds before the maturity date.
Rate and yield are two of the most important concepts associated with CDs and they can be quite confusing. The rate, often expressed as annual percentage rate (APR) is the rate of interest earned by the CD. The yield, or annual percentage yield (APY), describes the total amount that will be earned by the investor in one year. The APY is higher than the APR because interest compounds, meaning that interest earned earlier in the year will earn more interest as the year progresses. The APY is the number to focus on, because it reflects the amount of growth you'll actually receive. In addition to rate and yield, an investor should carefully research the maturity of the CD and any special features associated with it before investing.
There are more complicated types of CDs that offer variable rates and other features. For example, some long-term CDs may be "called" by the banks that issue them. After that point, interest is no longer paid on the issue. A bank might choose to do this if interest rates decline and it can sell other CDs at a lower rate of interest. This brings up another negative feature of CDs. There is significant interest rate risk, meaning that if interest rates rise after the CD is purchased, the investor cannot take advantage of the more favorable rate.
The Money Market
The money market is used to buy and sell fixed income securities. Unlike the bond market, money market investments are short-term. These short-term loans usually have a maturity of less than six months. Money market securities are generally very safe investments which return a reasonable interest rate that is most appropriate for temporary cash storage or short-term time horizons. Bid and ask spreads are relatively small due to the large size of the market.
Individual investors often must invest in money market funds to participate in the money market because the securities themselves are usually traded only in amounts totaling $100,000 and higher. Money market funds are a highly liquid way to invest in money market securities without the high-denomination barrier of investing directly.
Types of Money Market Instruments
U.S. Treasury Bills are an extremely low-risk investment vehicle. T-Bills are auctioned off and guaranteed by the government. They mature in either 3 months, 6 months or 12 months, meaning that they have short enough terms to avoid the risks associated with rising interest rates. The bills are sold at a discount from face value and can be redeemed for their full value at maturity. Purchase amounts range from $10,000 to $1,000,000 and, because of an active secondary market, the bills are highly liquid.
Commercial paper is available in a wide range of denominations. These promissory notes are short-term debt instruments issued by companies. They can be of either the discounted or interest-bearing variety. They usually have a limited or nonexistent secondary market. Commercial paper is usually issued by companies with high credit ratings, meaning that the investment is almost always relatively low risk.
There are a variety of other notes available that vary in terms of return, risk and liquidity, but all are relatively safe investments that return a modest interest rate.