Many investors expect interest rates to rise in the future, and with interest rates near all-time lows they are reluctant to invest in longer-term securities. It is important to understand that waiting for higher rates may have a cost: An investor who holds cash and waits until interest rates increase will forgo the higher yields currently available from bonds with a stated maturity. Even in the current interest rate environment, choosing to stay in cash as opposed to extending maturity could surrender a significant amount of income and total return over the life of the investment. Below are a few scenarios to shed light on the topic and help clarify the true cost of waiting.
In the following circumstances we assume an investor has $100,000 to invest in a money market instrument or a corporate ‘A-rated’ bond for a two-year period. To help illustrate the effects of waiting during those two years, we examine what the breakeven income will be for money market rates if they were to increase after 6, 12 and 18 months.
Let’s first take a look at what would happen if an investor chose to wait two years for rates to increase, only to realize that rates did not move at all during this time frame. We assume that money markets return 0.02% per year, while a two-year corporate A-rated bond yields 1.90% (for the corporate bond yield we are using the indicative rate provided by Bloomberg’s Corporate ‘A-rated’ yield curve). It should be noted that money market rates typically follow the direction of the Federal Funds Rate and often do so at a slight lag. For the purposes of this discussion, it is assumed that the investor does not need access to the money until the end of a two-year time period.
The following table shows three scenarios in which short-term interest rates could rise in the future: at 6, 12 and 18 months. In each scenario, we assume that the initial money market rate of approximately 0.02% remains constant for 6, 12 or 18 months, respectively, before beginning to rise steadily until the end of the two-year period. The resulting breakeven rates reflect the level that the final money market rate would have to reach in order for the money market investment to match that of investing in a 2-year ‘A’ rated corporate bond held to maturity.
For example, earning a beginning rate of 0.02% for 12 months, the money market rate will have to gradually rise to a final yield of 4.34% for the return on money markets to equal that of a 1.90% corporate bond over the same two-year period. Put another way; even if rates began increasing in one year, it would take a money market rate increase up to 4.34% to merely match the rate of a current 2-year corporate bond held to maturity.
Another way of thinking about this concept is to examine what would need to happen to the rate of corporate bonds rather than the money market rate. In the scenario above, we highlight several holding periods and indicate the rate that a corporate ‘A’ rated bond would need to rise for a cash investor to break even. For example, an investor who spends one year in cash at 0.02% and the following year in a corporate bond yielding 3.78%, averaging ~1.90% over the two years, would break even to the original corporate yield/rate of 1.90% per year. In other words, an investor who stays in cash for one year would need the 2-year corporate rate to increase from 1.90% to 3.78%, nearly doubling, to break even over a two-year investment horizon. Looking at the table above, it is apparent that the longer an investor waits to invest at current rates the higher the rates need to go to compensate for lost time.
As evidenced by the two-year scenario above, the cost of waiting for interest rates to rise is considerable. The increase in interest rates in the future may not be sufficient to offset the negative impact on income during the holding period. Currently, the steepest area of the yield curve (between two and 10 years) is where an investor receives the greatest amount of extra yield for extending maturity. This is also the area of the yield curve in which the cost of waiting is highest. We continue to stress cash flows and diversification by staggering investments among different bond maturities to create periodic reinvestment opportunities and potentially optimize returns over time. Should rates increase, a portion of the portfolio could be reinvested at the higher prevailing rates, as a portion of the portfolio will always be near maturity.
It is important to note that this strategy is dependent upon holding the securities until maturity. If funds are needed prior to maturity, proceeds may be less than the original investment if interest rates have risen since the purchase.
Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility and duration.
The author of this material is a trader in the Fixed Income department of Raymond James & Associates (RJA), and is not an analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions that may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James financial advisor. Past performance is no assurance of future results.
Diversification does not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal. This communication is intended to improve the efficiency with which financial advisors obtain information relevant to their client's taxable fixed income holdings. This information should not be construed as a directive from the RJA Taxable Fixed Income department to buy or sell the securities noted above. Prior to transacting in any security, please discuss the suitability, potential returns and associated risks of the transactions(s) with your client. For additional disclosure information on any security listed in this publication, please contact the Taxable Fixed Income desk at 727.567.2040.
The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Trading ideas expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Investors are urged to obtain and review the relevant documents in their entirety. RJA is providing this communication on the condition that it will not form the primary basis for any investment decision you may make. Furthermore, because these are only trade ideas, investors should assume that RJA will not produce any follow-up. Employees of RJA or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. RJA and/or its employees involved in the preparation or the issuance of this communication may have positions in the securities discussed herein. Securities identified herein are subject to availability and changes in price. All prices and/or yields are indications for informational purposes only. Additional information is available upon request.