Money Funds a Good Bet

I am considering putting some extra cash in a money-market fund, a short-term bond fund, a high-yield fund or a medium-term bond fund. But I'm concerned about loss of capital if interest rates rise. At the same time, I wonder how long I can expect money funds to yield 5% or so, when they have paid much less in the past. What should I do?

Yes, money funds have paid less in the past. Rates fell below 1% earlier this decade. But they've also paid more, and sometimes a lot more. In 1981, the typical money fund returned around 17%.

Don't look for either extreme anytime soon. Returns on money-market funds are linked to moves in short-term interest rates. The Federal Reserve has left those rates unchanged for 11 consecutive months, and this could continue for some time. If inflation accelerates, the Fed is likely to boost rates; if the economy weakens noticeably, the Fed will cut short-term rates.

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Long-term interest rates, which are determined by investors buying and selling in the bond market, have been unusually stable the past couple of years, and we don't expect any big moves. But with long-term rates as low as they are, there is a lot more risk of rates rising (and bond prices falling) than there is of rates falling (and bonds appreciating).

So money-market funds make a lot of sense for cash you can't afford to lose. The only risk is that your income will decline if the Fed cuts short-term rates. If you want to boost your yield without taking on too much additional risk, consider Fidelity Floating Rate High Income, which invests in adjustable-rate bank loans. The fund recently yielded 6.4%, and we named it to our list of The 25 Best Mutual Funds.

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.