Emergency funds: Risk versus returns

My emergency fund is in a "high yield" savings account that pays 0.75%. Would it be irresponsible of me to invest it in another vehicle that might offer better returns without inappropriate risk, say an ETF or bond fund? -- Jeff S., Mass.

After four straight years of short-term interest rates slinking along below 1% -- actually, at less than 0.5% most of that time -- savers have come to regard the term "high yield savings account" as an oxymoron, like jumbo shrimp or political leadership.

No one knows what rates will do in the coming year. But last October the Federal Open Market Committee said it would likely keep its target for the federal funds rate, a bellwether for short-term interest rates, at 0% to 0.25% "at least through mid-2015."

The FOMC then said in December that it expected to keep the rate in the same range as long as the unemployment rate stayed above 6.5% and inflation remained under control.

I'm not in the business of predicting interest rates, but that suggests to me that rates aren't likely to climb significantly anytime soon, absent a major surge in the economy.

Given that outlook, I understand you might be tempted to invest your emergency stash in something that has a shot at more lucrative returns.

After all, stocks gained 16% last year and bonds returned just over 4%.

But while it's easy to see with the benefit of hindsight that you would have done much better owning stocks or bonds, it's quite another thing to know how you would fare in the future.

Stocks can go from sizzle to fizzle quickly, witness their near 60% loss from a market peak in late 2007 to the trough in early 2009. And while bonds aren't quite that volatile, they're not immune to setbacks, especially when interest rates rise.

My view is that if you really want to be sure that every cent of your emergency fund, both principal and any earnings, will be there whenever you need it, the prudent choice is an FDIC-insured account, whether it's a savings account, bank money-market account or short-term CD.

Yes, payouts are pathetically low. But security is your primary goal when it comes to emergency savings. So while you can shop around for the best deals at sites like Mint and Bankrate, you should still limit yourself to FDIC-insured accounts. Or, if you belong to a credit union, accounts covered by the National Credit Union Share Insurance Fund.

If you're willing to accept some risk of loss with your emergency stash, I suppose you could move a bit of your money into short-term bond funds. And theoretically at least, that risk should be relatively small.

If short-term rates rise by one percentage point, for example, a short-term bond fund with a duration of two and a half years would drop 2.5% or so, which might result in a loss of, say 1.5%, after allowing for the fund's yield for the year.

But the losses could be deeper should rates, tame now, spike at some point down the road. Besides, whenever you stretch for return, there's always the potential for nasty surprises, as investors in recent years found after buying auction-rate preferred securities, bank loan funds and certain short-term bond funds that had loaded up on risky mortgage-backed securities.

Bottom line: When parched for yield, investors will turn to virtually anything that promises to quench their thirst, even venturing into dividend stocks, annuities and foreign CDs.

Make no mistake, though. Once you leave the realm of FDIC-insured accounts, you are taking on more risk. That may be fine when you're shooting for higher returns with money you're investing longer term. But if you want to be certain your money will be there in the event of an emergency, stick to what's truly secure -- and accept the low payout as the price for peace of mind.