The term "cash equivalents" refers to financial instruments with a short-term maturity (typically less than a year). With most cash equivalents, the four major factors in deciding whether to purchase the instruments are (1) the financial strength of the issuer, (2) the maturity date of the instrument, (3) any early withdrawal penalties, and (4) the yield to maturity.
The financial strength of the issuer indicates the probability that you will be repaid when the instrument matures. The maturity date refers to how long you must wait before you will be repaid. An early withdrawal penalty is the amount of money you must forfeit if you surrender the instrument before the maturity date. Finally, the yield to maturity is the amount of interest (and possible gain in principal amount) you will receive for holding the instrument until it matures. The following discussion looks at how to analyze the various cash equivalents that are available to an individual investor in today's marketplace.
Checking and Savings Accounts
Probably the most widely used cash equivalents are checking and savings accounts at a bank, credit union, or other financial institution. Even though most checking accounts pay little or no interest, many online banks now offer (our favorite cash equivalent) high-yielding savings accounts with full FDIC insurance. These savings accounts offer upwards of 5% interest as well as fast, convenient access to your money at all times.
The analysis you should do before opening a savings account is similar to what you should do before buying a certificate of deposit. You should make certain that the institution is financially sound and has federal deposit insurance. This means that if the financial institution collapses, your deposits will be protected by the federally backed deposit insurer, up to a certain amount (usually $100,000; $250,000 for retirement accounts).
Treasury Bills
When you analyze Treasury Bills, the financial strength of the issuer and early withdrawal penalties are usually not considerations. Treasury bills (sometimes called T-bills) are backed by the full faith and credit of the U.S. Treasury--these are among the safest investments you can make. Early withdrawal penalties are also usually not a factor because T-bills can be sold in the secondary market at any time, and there is a very active market for them. You don't have to hold them until maturity. (Of course, you may have to pay a small commission if you want to sell T-bills on the secondary market before they mature.)
The only considerations, therefore, are the yield and the maturity date of the instruments. Because they are among the safest investments, T-bills almost always yield less (for a comparable maturity) than other more risky cash equivalents, such as commercial paper. Thus, the most important issue in analyzing T-bills is whether you want to accept a slightly lower yield (compared with other cash equivalents) in return for the assurance that there is almost no possibility that the issuer--the U.S. Treasury--will default on the repayment when the bills mature. The only other consideration is how long a maturity you want. T-bills are issued in 13- or 26-week maturities (although, as noted, you do not have to hold T-bills until maturity).
Certificates of Deposit
A short-term certificate of deposit (CD) issued by a bank is also considered a cash equivalent. Repayment of the CD is backed by both the issuing bank and the bank's deposit insurer (e.g., the FDIC). Therefore, when analyzing CDs, you should consider the financial strength of the issuing bank (or other financial institution) and make certain the institution has federal deposit insurance. This insurance will usually cover up to $100,000 of an individual's deposits in one financial institution (retirement accounts are generally insured up to $250,000). If the financial institution defaults on its obligation to repay the CD, the federally backed deposit insurer will cover the bank's obligation. Another consideration in analyzing CDs is whether there are early withdrawal penalties. Many financial institutions impose a penalty if you cash in the CD before its maturity date, so plan to hold the CD until maturity.
Repurchase agreements
A repurchase agreement (known as a "repo") is a type of cash equivalent created when a lender (usually a large financial institution) sells marketable securities to a buyer and agrees to buy back the securities a short time later for a higher price. The time period between the initial sale and the buyback may be as short as overnight or a few days. Usually, only large institutional investors (such as money market mutual funds) purchase repos. However, individuals may purchase repos if they have enough money to invest. Like commercial paper, repos are usually issued in denominations of $100,000.
The analysis for the purchase of repos is similar to the analysis you should do before you buy commercial paper. You want to research the financial strength of the issuer to make certain that the company can repay the repo amount to you when it becomes due. (When you buy a repo, you are essentially lending money to the issuer for a short period of time.) When you buy a repo, therefore, there is a slight risk of default if the buyer or seller has financial troubles. Another consideration when buying a repo is the maturity date of the instrument, whether it is a short- or a longer-term agreement. You should also compare the yield on the repo with the yield on similar instruments.
Other Cash Equivalents
In addition to the cash equivalents previously discussed, there are other money market instruments, such as Eurodollars and Banker's Acceptances. Like commercial paper and repurchase agreements, these instruments are purchased almost exclusively by large institutional investors because they are usually issued in large denominations. However, an individual with enough money could purchase them. The analysis you should do before purchasing these types of instruments is similar to what you should do before buying repurchase agreements or commercial paper. You need to research the financial strength of the issuer to make certain that the institution can repay the amount you invest. Be aware, too, of the maturity provisions, and compare the yields with those of similar instruments.
Money market mutual funds
One of the most popular cash equivalents is a money market mutual fund, a type of mutual fund that invests solely in cash equivalents and other money market instruments. A money market fund may purchase T-bills, commercial paper, repos, Eurodollars, and similar types of instruments. An individual can then buy shares in that fund. There are also subcategories of money market funds, such as those that invest only in T-bills or commercial paper. There are also funds that require very large minimum deposit amounts. These are just a few of the varieties of money market funds.
The two main considerations when analyzing a money market mutual fund are the safety of the fund and its yield. In general, all money market funds have been very safe. However, if your primary concern is the safety of your money, then you should invest in a money market mutual fund that invests only in government securities (such as T-bills).
The yield on a money market fund will depend, in part, on the type of securities in the fund--a money market fund with only T-bills will yield slightly less than a fund with more risky money market instruments. Furthermore, because the money market fund takes an annual management fee, the yield on a money market fund tends to be less than if you bought the money market instruments directly.
Money Market Deposit Accounts
Another type of cash equivalent is a money market deposit account. This is a type of federally insured savings account that banks, savings and loan associations, credit unions, and other financial institutions offer to their customers. The financial institution pools the money it receives from depositors and then invests the money in high-yielding, short-term debt instruments such as T-bills and commercial paper. The money market deposit account usually pays a higher rate of interest than that paid by other savings and checking accounts. Although technically a savings account, a money market deposit account usually allows the depositor to write a limited number of checks against the account each month.
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