High interest rates: where to stash cash

Cash can interfere with long-term investment goals, including retirement planning. (Photo: 123RF)

With the Bank of Canada’s overnight rate at 5% since April 25, Canadian investors find themselves in a very different situation than they were a year ago. This rapid pace of monetary tightening – the most aggressive since the 1990s – had a significant impact on lending and savings.

Mortgage rates have more than doubled, making home ownership increasingly unaffordable for many people. At the same time, yields on savings accounts and guaranteed investment certificates (GICs), which provide better returns for risk-averse investors, soared.

With inflation stubbornly high and the Bank of Canada not expecting to reach its 2% target until 2025 at the earliest, any future rate hike, however unlikely, is not entirely out of the question. Canadians must therefore prepare for interest rates to remain high until 2025. In this new higher rate environment, investors must rethink how they manage their cash flows.

Holding your investments in cash is not the most beneficial investment strategy. When the inflation rate rises, the value of cash decreases over time, reducing the potential return on investment. To protect themselves against loss of purchasing power and missed growth opportunities, investors should look for options that offer returns at least equal to or better than the rate of inflation.

Maximize the return on savings accounts

With interest rates rising, interest rates on savings accounts have become much more attractive. Many major banks and online institutions now offer rates of 4-5% or even more on savings accounts. By placing their cash in these high-yield savings accounts, investors can earn a good return without taking significant risks.

The main thing is to shop around and compare prices between different providers. Online banks and fintech companies often offer the most competitive returns on savings accounts, so it’s worth exploring these options in addition to the big banks.

Consider investing in GICs

GICs are a beacon of hope amid rising interest rates and have become a more attractive cash management tool in the current economic environment. They offer guaranteed returns and are valued for their low risk profile. Depending on the length of the lock-in, GICs can offer a juicy yield ranging from 4% to 5.5% starting in April 2024, making them a relatively risk-free investment option.

When the GIC matures, investors can reinvest the funds into another short- or medium-term GIC, creating a floating portfolio of fixed income investments with a predictable return. This strategy allows investors to benefit from high returns when rates rise without being locked into a single GIC for the long term.

Short-term bond fund

Investors with a slightly higher risk tolerance and looking for a better return than savings accounts or GICs may want to consider short-term bond funds. These funds invest in a diversified portfolio of high-quality, short-duration fixed-income securities that offer better returns than cash while maintaining relatively low volatility.

What makes short-term bond funds particularly attractive is their ability to quickly adjust to rising rates. When high-yield bonds mature, the fund can use the proceeds from those bonds to invest in newer bonds that pay higher interest. The fund’s total interest income thus remains stable even when interest rates rise.

Alternative cash management strategies

In addition to traditional savings accounts and fixed income instruments, Canadian investors may also consider the following cash management strategies:

High-interest checking accounts: Some banks and fintech companies are aggressively offering checking accounts that offer interest rates comparable to savings accounts. Many of these would entice consumers to switch providers in exchange for a high, time-limited interest rate that far exceeds what your checking account can offer.

Money market funds: These are mutual funds that typically invest in high-quality, short-term debt securities and may offer slightly higher returns than savings accounts. They offer investors a safe and liquid way to get a modest return on their cash. Many Canadian financial institutions and investment companies offer this low-risk option to investors looking for stability and liquidity in their investment portfolios. In addition, these funds are subject to regulation by financial market regulators.

Ultra-short-term bond funds: These are investment vehicles (including mutual funds or ETFs) that invest in fixed income securities with short maturities, usually less than one year. These funds offer investors a relatively safer way to invest their cash, potentially offering higher returns than traditional savings accounts or money market funds.

Similar to short-term bond funds, but with an even shorter duration, these funds can be useful for maintaining liquidity as rates rise.

The key is to carefully evaluate the risk-return profile of any alternative cash management strategy to ensure it matches your investment objectives and risk tolerance.

Finding the right balance

Cash can interfere with long-term investment goals, including retirement planning. While it is important to optimize liquidity, it is also crucial for investors to maintain a well-diversified portfolio that includes other asset classes such as international equities, commodities and, in some cases, real estate.

Cash should generally represent a relatively small portion of a balanced investment portfolio, with the majority allocated to growth-oriented assets.

The specific allocation of cash depends on the investor’s personal circumstances, including his time horizon, risk tolerance and investment goals. As a general rule, financial experts often recommend keeping three to six months of living expenses in readily available cash or cash equivalents, with the rest of the portfolio invested in a mix of stocks, bonds and other assets.

By finding the right balance between cash, fixed income and growth-oriented investments, Canadian investors can weather rising interest rates while positioning their portfolios for long-term success.

By Vikram Barhat for Morningstar

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