Where should an investor park cash?

The Federal Reserve’s interest rate cut on Tuesday to 0.25% to 0% poses some serious challenges to cash management for investors. The yield on 30-day and 90-day T-bills is now at just 0.01% this morning and actually turned negative briefly last week as nervous investors continue to lunge after super-safe bills.

A negative interest rate implies investors are paying the government to park cash and not the other way around. It marks the first time since 1940 that short-term bills have turned negative, if only temporarily.

But the Fed’s historical rate cut this week now poses serious business risks to mutual fund companies offering money-market and government money-market funds because the yield is too low to cover fund expenses. Several mutual fund companies have recently closed their money-market funds, including Credit Suisse and an institutional money-market fund managed by Dreyfus Funds.

The seven-day average yield on taxable money funds fell to 0.88% on Tuesday from 0.94% a week earlier, according to iMoneyNet. Last year, money-market funds yielded north of 4%. The Fed has cut short-term lending rates ten times over the last fifteen months to quash the ongoing credit squeeze still plaguing U.S. and international capital markets.

Money-market funds are about to yield much less now that the Fed Funds rate is effectively almost 0% -- less than Japan’s target rate of 0.30%. Pretty soon, investors will start to lose money as fund expenses devour principal.

If you hold money-market funds, I strongly suggest redeeming these funds and placing them into a combination of 12-month CDs at two or more banks (J.P. Morgan Chase, Wells Fargo), short-term U.S. Treasury bonds and even investment-grade corporate debt. The latter is especially attractive now following a rare crash in September and October; the biggest U.S. banks continue to pay about 7% or more for investment-grade bonds that are now guaranteed by Uncle Sam.

I would also suggest gold. With interest rates now at 0%, the cost disadvantage to holding gold has vanished because high quality Treasury bond yields have plummeted while T-bills pay nothing. Gold will probably safeguard your capital better than paper money in this environment.

The lowest interest rates in more than six decades will undoubtedly fuel a wave of yield-hungry investors seeking higher returns. The best defense to protect your cash balances is to diversify among the above sectors to boost your effective yield without compromising on safety of principal. With rates basically at 0%, investors have no choice but to look elsewhere as deflation continues to gain momentum, threatening income based investors.