How to Survive Fed Shock

There are ways to hang on to higher rates

Interest rate cuts act as a pick-me-up for the economy, but when it comes to your cash stash, they're a real downer. Under pressure from the Federal Reserve Board, yields on money-market mutual funds are plummeting: The average fell to 5.38% on Feb. 13 from 6.14% in December, before the Fed sliced one whole percentage point off the Fed funds rates according to Money Fund Report. Rates on bank certificates of deposit are also shrinking fast. The average one-year CD pays 4.64%, down from 5.45% just six weeks ago, says Bankrate of North Palm Beach, Fla.

You can't fight the Fed--and its chairman, Alan Greenspan, is pointing to still-lower rates. But smart investors can take steps to grab what's left of higher interest rates and hang on to them for as long as possible. Here are some suggestions:

-- Money-market funds. Yields on these funds, which invest in very short-term government debt and bank and corporate issues, will continue to fall. But you can enhance your returns by switching to funds with longer maturities, say, 60 or more days. Those funds will take two months to turn over their portfolios. When rates are falling, their yields will come down more slowly than those with shorter maturities. If possible, switch to funds with higher minimum investments. Such funds have lower expenses, resulting in higher yields. Vanguard Admiral Treasury Money-Market Fund has a 71-day average maturity--and an above-average 5.79% yield. The minimum investment is $50,000.

-- Ultrashort bond funds. These mutual funds invest in securities whose maturities are too long for money-market funds but not long enough for short-term bond funds. They maintain an average maturity of about six months, so there's little risk to principal. Falling rates will eventually catch up with these funds, too, but their slightly higher yields will hang on longer.

One veteran player is the Strong Advantage Fund, which is currently yielding 7.12%. This fund maintains relatively high returns by lacing the portfolio with lower-grade bonds, says Morningstar analyst Peter DiTeresa. About a quarter of the fund's assets is invested in bonds rated BB or lower.

-- Short-term municipal-bond funds. These yields are a lot lower, but hey, they're tax-free. Take a look at the brand-new Federated Municipal Ultra Short Fund. It has a maturity of about six months, and the current yield is 4.54%. "It's just one step away from money-market funds--a step most people miss," says co-manager Mary Jo Ochson. The fund mixes short-term bonds with variable-rate demand notes that adjust to market rates every seven days. That evens out the volatility. Others of this ilk include Strong Muni Advantage Fund, yielding 4.21%, and Nations Short-Term Municipal A, with a 4.45% yield.

-- Savings bonds. Investors can buy up to $30,000 per year in I Bonds, which are free from state and local income taxes and can be cashed after six months. And now is a good time to pick up I Bonds, because the current 6.49% yield is good through April. At that point, the Treasury Dept. will recalculate yield, and it's likely to be lower. The yield consists of a fixed rate that remains the same for the life of the bond and an inflation rate that's subject to change twice a year. Traditional Series EE Savings Bonds now yield 5.54%, and they reset every six months, too, but there is no built-in inflation protection.

-- Commercial paper. This is unsecured debt, but it's relatively safe if issued by highly rated banks and corporations. Available through major brokerage firms, such paper sports maturities of up to nine months and generally yields a little more than half a percentage point over money-market rates. AAA issuers include GE Capital and United Parcel Service (UPS). A-rated debt, such as Ford Motor's (F) finance unit and GMAC, can pay 1 1/2 points higher, but they're riskier. The catch with commercial paper is that you generally have to buy big blocks, say, $100,000 worth or more.

By Mara Der Hovanesian

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