Imagine a toolbox with only one tool: a hammer. The hammer is versatile for projects big and small, but if you’re building a house, as we all know, a toolbox with a lonely hammer won’t get the job done.
In the same way, building a financially resilient nonprofit needs a variety of financial planning tools to fund the philanthropic mission. Yet several small to midsized nonprofits park all their funds—whether for short or long-term needs—in a checking account. Few nonprofits take advantage of fixed income markets, the Swiss Army knife of the investment world, providing an income stream, a bit of principal protection, liquidity and sometimes a decent rate return.
The stock market gets most of the media attention in turbulent times, yet the fixed income or bond market, generally a boring corner of the overall investment ecosystem, is an important indicator of economic health. While the fixed income markets have taken a rare beating during the recent economic upheaval, rate increases by the Fed have provided nonprofits with more options to invest operational funds parked for a short time horizon. Nonprofit leaders should become familiar with the array of fixed income investments as they can provide returns at a lower level of risk, depending on an organization’s time horizon.
We summarize the most common of these fixed income investments below with what they are, when they’re suitable and the potential risks inherent in investing in them.
Money Market Fund
What is it? A mutual fund that invests in cash, CDs, Bankers’ Acceptances and Repos that mature in the very near term. Money market funds generate a small income stream but very little tal apprecian or increase in value.
What is it used for? Money market funds are appropriate for parking money temporarily in anticipation for a short-term cash outlay.
What else? A Money market fund maintains a net asset value (NAV) of $1 per share. Any earnings generated through interest on the portfolio holdings above $1 per share are distributed to the investors in the form of dividend payments. On very rare occasions, a money market fund may “break the buck,” a condition in which the investment income fails to exceed its operating expenses or investment losses. In the aftermath of the Lehman Brothers bankruptcy, government legislated that money market funds cannot have an average dollar-weighted portfolio maturity exceeding 60 days.
Risk Level: Low
Certificate of Deposits (CDs)
What are they?
A bank product that earns interest on a lump sum for a fixed period. CDs typically offer higher rates of interest because the funds must remain untouched through the term of the CD. If the CD is liquidated before maturity, an early withdrawal penalty is incurred. While a CD earns higher rates than a bank savings account, it will not increase in value and the interest rate is fixed even if prevailing interest rates increase during the term.
What is it used for?
CDs are appropriate for parking nonprofit funds temporarily in anticipation for a cash outlay at a known date. CDs are not volatile as stock and bond markets are and therefore should hold their principal value. Due to early withdrawal penalties, CDs are not appropriate as a nonprofit’s emergency fund where funds must be accessed at any time.
CD investments are protected by the Federal Deposit Insurance Corp. (FDIC) which provides insurance for banks, and the National Credit Union Administration (NCUA) which provides insurance for credit unions. When a nonprofit opens a CD account with an FDIC- or NCUA-insured institution, the organization’s funds are covered up to $250,000 so if the bank collapses—a rare event—$250,000 of funds will be returned to the account holder. Some banks offer CDs nationally and can offer as much as five times the industry average interest rate for every term, so it helps to shop around. For large amounts, this may be operationally inconvenient for a nonprofit.
Risk Level: Low
U.S. Treasury Securities
What are they?
Treasury securities are debt instruments auctioned off by the U.S. government to fund operations. It is effectively a loan to the U.S. government in which investors receive interest income and then the face value of the security upon maturity. Treasuries are issued in a variety of maturities.
Treasury Bills: four weeks to one year and do not pay periodic interest but are sold at a discount to the face value
Treasury Notes: two to 10 years with interest payments every 6 months
Treasury Bonds: 20 to 30 years with interest payments every 6 months
Typically, the longer time to maturity, the higher the yield, which equals the interest payments divided by the security price. All Treasuries have no default risk, guaranteed by the full faith and credit of the United States government. Treasuries can be purchased directly from the U.S. Treasury via the online platform TreasuryDirect or on the secondary market, where investors buy from each other, via a brokerage account.
What are they used for?
Treasuries have a variety of uses depending on investor need and time horizon. For short-term investors, Treasury bills or t-bills are a good alternative to CDs to park funds for a short period but do not require funds to be held to maturity in order to avoid penalties as with CDs. For intermediate and long-term investors, Treasury notes and bonds offer more safety but lower return over risker bonds issued by corporations.
Treasuries, like most bonds, have a market price that could be more or less than the investor paid. This means that while an investor can convert a Treasury to cash in one business day after selling the security, an investor may lose or gain depending on the gap between the purchase price and the ultimate sale price. Treasury prices are dependent on prevailing interest rates and economic sentiment. Treasury bonds maturing in over 10 years can experience a high level of price fluctuation.
Risk Level: Low to Medium
What are they?
Corporate bonds are debt securities issued by a company allowing it to borrow funds from investors for a fixed or variable stream of income payments. Like Treasury securities, corporate bonds come in a variety of maturities, typically one to 30 years. When the bond matures, the income payments cease and the original investment is returned to the investor. Investors in corporate bonds are exposed to credit risk, or in other words the ability of the company to repay investors, thereby making these bonds riskier than Treasury securities. To compensate for this increased level of risk, corporate bonds typically offer a higher level of return to investors. Corporate bonds range in their risk level with some companies rated as “investment grade”, which are deemed safer and lower yielding, while some companies are far less creditworthy and are termed “high yield”, for their increased return for the highest risk bonds.
What are they used for?
Corporate bonds are most often used to balance out a diversified portfolio that includes stocks. Over the long term, corporate bonds are typically less volatile than stocks which will dampen the overall changes in portfolio valuation. Bonds, whether government or corporate, also typically move differently in relation to stocks, as measured by the statistic correlation, which helps to reduce portfolio risk. Alternatively, some investors looking for a diversified portfolio that avoids the risk of stocks altogether may prefer a diversified, all-bond portfolio that delivers some return with less volatility.
Because corporate bonds are so varied in their risks and features, investors are typically best served by holding a large number of bonds across a variety of risks, often via a mutual fund or exchange traded fund. This way an investor can balance out exposure to lower credit bonds that offer higher yields with higher credit bonds with lower yields.
Risk Level: Medium to High
Small and midsized nonprofits that park large cash balances in the organization’s checking account might be missing out on the liquidity and return benefits of a broad array of fixed income securities. Contact us to learn how your nonprofit can deploy fixed income securities be financially resilient while serving your community with a robust portfolio of fixed income securities.
Talk to the financial experts at Fairlight Advisors to learn more about managing your nonprofit’s investments. Schedule a free consultation today!