Bogleheads

[gnosis]

We have about half of our emergency fund in a 2% savings account, and the other half in a one-year CD at 4.25% which will mature in about a week. I intend to continue putting about half of our emergency fund in savings for true emergency withdrawals without penalty.

With the maturing CD money, I was planning to start a CD ladder this time, spreading the money into 1-,2-,3-,4-, and 5-year CDs, ranging between 2-4%. But I am now considering putting that money into a Vanguard tax-exempt bond(s), since they're averaging about 3.5% historically, which equates to about 5% in a CD.

Is there any penalty if we needed to withdraw or sell funds from any kind of tax-exempt bond fund, as there is for CDs?

I know someone is going to tell me that emergency fund money should be put into any account that's not insured, like a savings or CD account. If it's used to buy bonds, there's a risk that some of it may be lost... albeit a low risk, especially with the Vanguard Short-Term Tax-Exempt Fund. The way I see it, losing $1,000 isn't a big deal. I've done far dumber stuff to lose more money than that before. The Short-Term Tax-Exempt Fund seems so low-risk and it clearly outperforms CD interest rates these days, so I figure why not?

If I go with a tax-exempt fund for now, I plan to move it out maybe next year or whenever CD rates go up to start a ladder. It just doesn't seem like a good time to start a ladder because the rates are so weak these days.

What about $12k into the tax-exempt fund and $3k into a 5-year CD for now, eventually to start a ladder when CD rates improve?

[fluffyistaken]

Definitely CDs or other FDIC-insured accounts for emergency funds. Municipal bonds can and do go down in value. Plus CDs can be breakable which is very beneficial if the interest rates rise a lot (which would be one of the scenarios when bonds go down in value). Take risk elsewhere, not with the emergency fund.

[medgar]

Gnosis,

I tried for extra returns (Bond fund) on my emergency fund before and was burned when my company had a lay off last year. I will not do that again.

It is hard to watch a lump of cash not make any money. I do ladder but only in safe investments.

1. ING account 6-8 months worth
2. CD Ladder second layer (If rates are bad, I just put it in ING account for flexibility. Will wait til rates go up and rebuild ladder)

I have a tennis buddy who has added a 3rd tier with bonds through his roth ira due to the fact you can take out investments tax free not earnings. He has is 2 years or more emergency fund parked their. I'm not that conservative.

Good luck.

[LongDistanceRunner]

Instead of a CD ladder, one very safe place (and very liquid place) to store part of your emergency fund would be an I-bond. For the first 5 years you would have a 3-month interest penalty for redemption.

Look for the new I-Bond rate in November (it should be at least 3% assuming a real fixed rate of zero percent) and you can purchase up to $10,000 ($5K on paper and 5K using Treasury Direct) in the end of November. Interest is paid from the 1st of the month no matter what day you buy the bond. You may purchase up to $10,000 each year.

Remember too that I-bond interest is not taxed until the bond is redeemed (you also don't have to redeem the entire bond) and the interest is never subject to state or local income tax.
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[nisiprius]

I second LongDistanceRunner's point about series I savings bonds. Of course it's best if you commit to it well in advance. I feel very good about having well over a year's living expenses in I bonds that are all more than five years old. The biggest problem is they're earning such great rates that I would really hate to have to redeem them!

I'm not so sure about CDs for emergency money. First, be absolutely sure you've read the terms and conditions and that there are no restrictions (as distinct from penalties) on early withdrawal.

Second, if there is, let's say there's a penalty of six months' interest for early withdrawal, then early withdrawal could mean taking a hit of 1 or 1.5%. The biggest wiggles I see in the Short-Term Tax Exempt fund aren't any bigger than that. And you only hit one of those wiggles if you're unlucky, whereas you're certain to get hit by the CD withdrawal penalty.

So a CD that you might have to make an early withdrawal from does incur a small amount of risk: you might end up getting robbed of the little bit of extra interest you expected it to earn. I've always ruled out CDs for emergency money for that reason.

Now I have not invested in Short-Term Tax Exempt either, mostly because I think it is just basically unsound to shift from "cash" to "bonds." But staring at the chart it doesn't look to me as if it would be crazy nuts to use Short-Term Tax Exempt instead of a CD.

The biggest reservation I have is: why the heck is Short-Term Tax Exempt paying so much? To this eyeball it looks as if it's just paralleling Prime money market with a little bit of a lag, meaning maybe it's going to flatten out soon??? I've no idea; just wondering. That wouldn't be a problem in itself, but I do find it soooo annoying when I go to the trouble of rate-chasing only to have my spiffy new account cut its interest rates immediately after I open it.

Now there's another point, which is that it's nice if your emergency funds are immediately accessible and don't require placing a trade and waiting a week for the funds to show up in your bank balance and another week for them to show as "available." It's also nice if they are at a local bank where they will issue you a teller's check if you need one.
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[LongDistanceRunner]

nisiprius wrote:

[retcaveman]

For what it's worth, in January of this year my I Bonds were paying a combined rate of 6.05%. They are currently "paying" 0%. Nevertheless, I have earned a pretty fair, safe, state tax-free return of 29.16% since purchasing them in 2003.

From the Treasury Direct website:

"The I Bond earnings rate is a combination of two separate rates; a fixed rate and an inflation rate:

Fixed Rate:
Announced each May and November
Applies to all bonds issued during the six months period beginning with the announcement date.
Remains the same for the life of the bond
The Secretary of the Treasury, or the Secretary’s designee, determines the fixed rate of return. The fixed rate is established for the life of the bond. The fixed rate will always be greater than or equal to 0.00%. However, the fixed rate is not a guaranteed minimum rate; the composite rate could possibly be less than the fixed rate in deflationary situations.

Inflation Rate:
Announced each May and November
Based on changes in the Consumer Price Index for all Urban Consumers (CPI-U)
Is combined with the fixed rate to determine the earning rate of the bond every six months*
In certain deflationary situations, the semiannual inflation rate may be negative. Negative semiannual inflation rates will be used in the same way as positive semiannual inflation rates. However, if the semiannual inflation rate is negative to the extent that it completely offsets the fixed rate of return, the redemption value of a Series I bond for any particular month will not be less than the value for the preceding month."

Here's how the composite rate for I bonds issued May 2009 - Oct. 2009 was set:

Fixed rate = 0.10%
Semiannual inflation rate = -2.78%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0010 + (2 x -0.0278) + (0.0010 x -0.0278)]
Composite rate = [0.0010 + -0.0556 + -0.0000278]
Composite rate = [-0.0546278]
Composite rate = -0.0546
Composite rate = -5.46%
Composite rate = 0.00% (Composite rates are never less than zero)

[LongDistanceRunner]

retcaveman wrote:

[stratton]

Vanguard Short Term tax-exempt is ~1.1 year duration so its not too bouncy. Vanguard's other short term bond funds are ~2.5 year duration. The Ltd Term tax-exempt is the equivalent to those with ~2.5 year duration.

Paul

[larmewar]

You must be looking at Long Term TE's 3.6% YTM. VG shows Short Term and Limit Term TE as having YTM 1.0% and 1.6%, respectively. I think the 5.5 year duration for IT TE is too long for emergency funds. Would you buy a 5 yr CD for emergency funds?

Lar

[tfb]

"Histoically" is a bad way to look at it. You can't buy history. You have to go by the current yield. Use the YTM or 30-day SEC yield, not the distribution yield. 1% isn't so hot.
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The Finance Buff

[ramsfan]

Gnosis, where do you have a 2% savings account? That is a great rate in the current environment!

[nisiprius]

[linuxizer]

[sportal]

[gnosis]