A question that investors need to ask themselves today: should I choose a longer-term bond/bond fund when money market funds are yielding more than 5% with no risk (however there is interest rate risk)? With money market yields at their highest level in years, it’s not necessarily an easy decision.
This perspective has some validity, especially if you expect rates to rise. In that case, money market rates would likely increase while longer maturity fixed income would suffer. However, if you believe the Federal Reserve’s indication that rate hikes are unlikely and you expect the next rate move to be lower, then moving into longer duration bonds makes sense.
As an example, investing in a money market fund today yields a little over 5%, which represents the maximum possible return (assuming no further Fed rate hikes). While you won’t lose money, your returns could drop below 5% if the Fed cuts rates. Essentially, 5% is the ceiling, with only potential downside.
On the other hand, even a modest 1% rate cut by the Fed can potentially push fixed income returns (like those in the Bloomberg Aggregate Index) to over 10%. And a more significant rate cut (like 2%) could drive total performance to over 16%+. The idea that the next move the Fed initiates is a rate cut makes a strong case for choosing moderately longer maturity fixed income investments over money market funds.
-Paul R. Rossi, CFA
P.S. If you want to dig a bit into the mechanics of bond pricing, keep reading.
What is the relationship between interest rates and bond prices, and how is it calculated?
For those that are a little more math inclined, it’s called Modified Duration, and it measures the price sensitivity of bonds to changes in interest rates. In a nutshell, bond prices and interest rates are inversely related, and the longer the maturity of a bond, the more sensitive the bond is to changes in interest rates.
t = time period
PV(CFt) = present value of the cash flow at time t
P = price of the bond
YTM = yield to maturity
n = number of periods per year (e.g., 2 for semi-annual payments)