Week 203 - Rainy Day Fund Updated

Situation: Since the Lehman Panic, leading nations have tightened and coordinated regulatory oversight of the financial sector. The largest banks are now fewer in number yet control more assets. Paradoxically, the US Federal Reserve has less freedom to manage a credit crisis, thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act. While money-center banks are required to have more equity behind every loan, Congress has used the Lehman Panic to set rules that may make future credit crises harder to tamp down. (With global debt per capita still growing, the next one can’t be far off.)

When those happen, there’s a 50:50 chance that the ranks of the unemployed will double, your children will have difficulty finding work to match their education, and you will want to stay employed past retirement age. Here at ITR, we encourage you to have a Rainy Day Fund big enough to cover your basic needs for 18 months. Interest rates may remain low for awhile, so we recommend you choose more bond-like investments than previously recommended in setting up a Rainy Day Fund (see Week 162). Here are your choices (see Table):

   Inflation-protected US Savings Bonds (www.treasurydirect.gov);
   3-month US Treasury Bills (www.treasurydirect.com);
   FDIC-insured Savings Accounts and Certificates of Deposit;
   Vanguard Money-Market Reserve Fund (VMMXX);
   10-yr US Treasury Notes (www.treasurydirect.gov);
   iShares 1-3 yr Treasury Bond Fund (SHY);
   iShares 3-7 yr Treasury Bond Fund (IEI);
   iShares 7-10 yr Treasury Bond Fund (IEF);
   Gold bullion;
   Vanguard Short-Term Treasury Bond Fund (VFISX);
   Vanguard Interm-Term Bond Index Fund (VBIIX);
   Shares of Wal-Mart Stores (WMT), the only S&P 100 company whose stock grew more than 5% in value during the Lehman Panic;
   Shares of Johnson & Johnson (JNJ), the only AAA-rated company whose stock fell less than 20% during the Lehman Panic.

Among these 13 choices, 10-yr T-Notes are my favorite. Why? Because the bank where you have the checking account that accepts the electronic interest payments from the T-Notes you bought through TreasuryDirect will be happy to loan you money at a very low interest rate, if your FICO credit score is over 800. In other words, you'll have the best collateral and the lowest repayment risk. You’ll likely be granted an immediate loan in the same amount as the T-Notes in your TreasuryDirect account. You’ll only need to sign over future principal and interest payments until you’ve paid off the loan. The next best choice is to build up an FDIC-insured Savings Account at that same bank (or hold a lot of 3-month Treasury Bills in your TreasuryDirect account). 

You can invest in WMT and JNJ online at computershare, where it costs $1.00/mo to dollar-average your investment in each of those stocks. Columns J-L in the Table include the relevant BMW Method metrics (see Week 199 and Week 201) for both of those stocks, VBIIX, gold and the S&P 500 Index (^GSPC).

We recommend that you pick six of the 13 options listed above, assigning each to cover 3 months worth of your household expenses. Four of those options are insured against loss of principal: Treasury Bills, Treasury Notes, inflation-protected US Savings Bonds (ISBs), and Savings Accounts at an FDIC-insured bank. Use all 4 of those if you’re risk-averse. Inflation-protected US Savings Bonds are the most prudent and convenient choice for a Rainy Day Fund because those protect you against the ravages of inflation, and cost nothing (treasurydirect): Whenever you need money, just return to that website and pick the bonds you wish to redeem. The money will show up in your checking account the next business day. As with an IRA, interest payments that you’ve accrued over the years will be taxed as income. If you cash an ISB before 5 yrs have passed, you’ll forfeit one interest payment.

Bottom Line: Learn to pay your credit cards off every month, and set up automatic monthly purchases of inflation-protected Savings Bonds.

Risk Rating: 2

Full Disclosure: I dollar-average into WMT, JNJ, ISBs, and 10-yr Treasury Notes.

NOTE: In the Table, metrics that underperform our key benchmark (VBINX) are highlighted in red; metrics are brought current for the Sunday of publication.

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