The Next Victim of the Recession

With financial markets in turmoil over crunched credit and a contracting economy, cash has reigned supreme. Yet those of you who've stuck it out on the sidelines have already seen your interest income slide in recent months -- and that trend will only continue.

This time last year, cash investors had it pretty good. As the market slowly began what would eventually become a huge decline, many cash-starved banks offered premium rates on CDs and savings accounts. Now, though, the party's ending, and what banks will pay is falling back into line with rock-bottom short-term rates on Treasuries.

Cash doesn't pay
Look at some recent trends:

• The average rate on six-month CDs, which was at nearly 4.5% toward the end of 2007, now pays just 1.78%.
• Vanguard has had to close two of its Treasury-owning money market funds to new investors, because yields are so low. Currently, the investor-class version of the fund pays 0.34% -- which isn't much, but remains far greater than the average yield for such funds of 0.15% as of Dec. 31.
• Even on longer-term CDs, it's a lot harder to find good rates. Average five-year rates are below 2.8%, down by a third just since September.

With the Federal Reserve repeatedly lowering interest rates, and the government injecting tons of money into the economy, the glut of cash means lower rates for savers. Even banks near the top of the rate list, such as the banking units of Discover Financial Services (NYSE:DFS) and Capital One Financial (NYSE:COF), don't give the 5% yields you used to find.

What to do
So should you get your money out of the bank and into something that pays more? First of all, let's make sure we're talking about the right part of your portfolio.

For your emergency fund -- money you can use to cover several months of expenses if you lose your income or face an unexpected financial catastrophe -- don't take chances. The point of having an emergency fund isn't to maximize income. That money is there to be available to you whenever you need it.

But if you have extra cash that you've been planning to invest when the time is right, that's another thing entirely. Let's take a look at the various options.

• Bonds. Often, you can find better rates than your bank will pay by investing in bonds. Right now, though, the bond market is in disarray. Treasuries pay even less than most bank accounts. Corporate and municipal bonds, on the other hand, have attractive yields -- but they also carry certain risks, especially in the recession-plagued economic environment we face. So if you think bonds are supposed to be a sure thing, don't be so sure, and don't fool yourself.
• Gold and silver. Some see the government's actions to prop up the economy as a prelude to potential hyperinflation, which would potentially make cash worthless. Although converting everything you own to gold is an insurance policy most people can't afford to buy, having a small portion of your portfolio in precious metals can be valuable -- especially if it gives you peace of mind you wouldn't otherwise have.
• Dividend stocks. For income, you just can't beat stocks that pay dividends. While bank rates have fallen, the struggling stock market has pushed yields sky-high. Consider these stocks, all of which pay yields above the top five-year CD rate of 3.9% ...

Source: Yahoo! Finance.

Sure, dividend stocks don't give you the absolute safety you get from bank deposits. But on top of healthy income payouts, you also have the prospect to see capital gains if stocks recover from their recent losses. Then again, stocks could also keep falling -- but if you pick stocks that can afford to keep paying those dividends, you'll at least maintain your income.

As banks pay less and less interest on cash, you can expect more people to look for alternatives. Given how expensive safe investments have become, the best values are in riskier assets. If you can afford to take on some risk, now's a good time to do it.

For more on getting income from your investments, read about:

• Stocks that'll get you through the bear market.
• Why now's the time to invest.
• The best stock you can own.