This report explains how the “cost of waiting” in cash, as opposed to investing in bonds, has grown and the forward return profile of fixed income instruments is more balanced.

  • U.S. interest rates have risen from historically low levels in late 2021 into 2022, as the Federal Reserve has lifted their target for overnight rates and inflation has risen.
  • When yields are at or near zero, bonds generate relatively little income, but with these recent increases in interest rates, the income-generation capacity of a bond portfolio is much more substantial.
  • With these increases in rates and higher income generation, the “cost of waiting” in cash as opposed to investing in bonds has grown and the forward return profile of fixed income instruments is more balanced.

Fixed Income Investing

As the U.S. economy faced down the acute COVID recession in 2020, interest rates plummeted to historical lows. Even through the early phases of the recovery, stubbornly low inflation and easy monetary policy meant the yield generated by fixed income instruments was relatively low, functionally not that much more than the 0% returns investors earned from sitting in cash. But, what a difference nine months can make.

The rise in interest rates in the last months of 2021 into 2022 has been truly impressive. Higher inflation has encouraged the Federal Reserve to rapidly increase its target for overnight interest rates, and bond yields across maturities have risen as a result. Compounding these increases, credit spreads—the incremental yield offered by a corporate or municipal bond relative to its low-risk Treasury counterpart—have also increased. The net result is that fixed income portfolios are generating more income than at any sustained point in the past several years. Commensurately, the give-up for NOT being invested in bonds is also higher than in quite some time.

If an investor had placed $100,000 into the largest money market fund in the U.S. in January 2020, s/he would have earned 0.34% per annum, or about $343 of income by mid-2022, most of that in the first and last three months of the period. Over that 2.5-year stretch, the yield on a generic index of USD bonds called the “Aggregate Index” averaged 1.73%, forgetting for the moment about market value declines in long-term bonds. In this period, the cost of waiting in cash as opposed to bonds averaged about 1.39% per year, which is on the lower side of historical standards. That low relative income meant that, when interest rates rose in 2021-2022, the declines in longer-term bonds’ market value quickly overwhelmed the incremental income generated. The last 2.5 years are actually a rare example of an extended period in which cash generated better overall returns than owning bonds.

Today’s Environment

Today is very different than those last 2.5 years. Currently, the yield on that same Aggregate Index on June 30, 2022, is 3.72%, while the distribution yield on the same money market fund is 1.06%, for a difference of 2.66%, fairly high by historical standards. At these interest rates, the income difference between an investment in the aggregate U.S. bond markets and a money market fund is $2,660 per year for each $100,000 invested. As such, it would take a much larger increase in interest rates and decline in the market value of long-term bonds to overwhelm the higher income generation. While certainly possible in this volatile environment, a scenario in which further rising interest rates overwhelm income generation for an extended period seems unlikely.

More important is that, over time, 2.66% of additional income can really add up. If you wait six months to purchase a bond and remain in a money market fund, the yield on that Aggregate Index would have to rise to 4.02% in order for you to earn the same return as you would if you had purchased the bond today at 3.72%. If you wait 12 months, the required “break-even yield” jumps to 4.39%.

The chart, “Cost of Waiting: Holding Cash Over Bonds is Costly,” describes this relationship and underscores just how important this concept becomes the longer you wait to invest.

So, the question to ask is not “can I earn a better yield tomorrow?” Rather it is: “Will the yield I can earn tomorrow be enough to compensate for not earning a higher yield today?” The last 2.5 years have been an exception, but throughout the history of the bond markets, the answer to this question has usually been “no.” And in today’s environment, the give-up between money market and bond yields makes the cost of waiting even higher.




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About the author

Guy LeBas

Director, Custom Fixed Income Solutions

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