Where to invest cash now

By Bob Gorman, CFA, Chief Portfolio Strategist, TD Waterhouse

A man looks at his laptop while leaning over his kitchen counter.

While maintaining some cash for contingencies is prudent, many investors are sitting on inordinately high cash holdings.

At the moment, cash levels are extraordinarily high throughout North America. For example, south of the border, money market mutual funds currently total about US$3.6 trillion.

The cash conundrum

The problem for investors is that holding cash may not be rewarding at this point. Money market instruments such as Treasury Bills and money market funds currently have yields of perhaps 0.5%. After taxes and inflation, overall returns for cash are meagre. At the same time, investors are understandably leery of taking on much incremental risk. How, then, do you generate worthwhile incremental returns without a lot of risk?

Fixed-income alternatives

At this point, a general portfolio of high-quality, well-diversified corporate bonds yields just above 4% — far exceeding the 0.5% currently being offered in the money markets. The incremental yield is worthwhile; however, investors should be careful to diversify, stick to high-calibre issues and keep the term to maturity moderate.

Some investors today are concerned about the potential for much higher inflation in the coming years, reflecting massive government stimulus programs and their resulting large deficits. While we do not yet know if inflation will surge, one means of guarding against the risk of inflation is real return bonds (RRBs), which seek to provide investors with a return that varies based on the rate of inflation as measured by the Consumer Price Index (CPI).

These bonds are issued primarily by the federal government, are somewhat complex and are thinly traded, so you should research RRBs carefully before taking action.

Conservative equity alternatives

Historically, bond yields have been higher than Canadian common share dividend yields. Today, this is not necessarily the case, as dividend yields are often equal to or greater than bond yields.

Canadian dividends offer several advantages over bond interest. First, the Dividend Tax Credit makes a dollar of Canadian dividends roughly equivalent, on an after-tax basis, to $1.30 in interest. For instance, a Canadian bank’s dividend yield of 3.6% is roughly equivalent to a bond’s yield of about 4.6%. Second is the extremely important fact that many of the highest-calibre companies have regularly increased their dividends — often annually (see “A history of dividend growth”). These dividend increases boost investors’ current income, provide a hedge against inflation and tend to provide support for higher share prices over time.

Of course, dividends can sometimes be cut and even the best companies’ shares are subject to sharp sell-offs in tumultuous periods, as we saw over the past year.

What’s right for you

While maintaining some cash for contingencies is prudent, many investors are sitting on inordinately high cash holdings. For those investors who seek higher potential yields without adding to equity exposure, high-quality corporate bonds may be right for you, and these can be complemented by real return government bonds, where appropriate.

For those investors willing to add to stock market positions, Canadian companies with relatively high dividend yields and records of increasing dividends over time could provide incremental income and the potential for higher share prices.

Chart: “A history of dividend growth” shows the growth in dividend payouts for Canada’s 60 largest companies between March 2000 and June 2009 (iShares S&P/TSX 60 Index Fund).