Fidelity Investment Information for Investors

Why wait for interest rates to rise before putting your cash to work?

Not long ago, the conventional wisdom was that interest rates had nowhere to go but up. Then, a series of crises—from euro zone debt woes to conflict in the Middle East and North Africa to the Japanese earthquake—unleashed a flight to quality that actually helped keep rates low, illustrating the difficulty of predicting interest rates, even for veteran investors. That's why, says Ford O'Neil, co-portfolio manager of three Fidelity bond funds, "we haven't made big short-term interest rate bets."

Nor should other investors, in our opinion. But that is exactly what people may inadvertently be doing by leaving too much cash for too long in savings accounts or money market funds, where interest rates are historically low and unlikely to go much lower. Of course, most people need an emergency fund to deal with life's unexpected demands. Others have obligations coming due shortly. Still others need to offset very volatile investments with very stable ones. And for those needs, low-yielding but highly liquid accounts can work well. But if you are an income-focused investor, there are many potentially higher yielding options to consider for money you won't need for three to five years.

What are you waiting for?

So why are investors holding near-record levels of cash in low-yielding accounts? Some may still feel paralyzed from the 2008 market meltdown. Others may have ridden the rebound that took the S&P up 80% from its March 9, 2009, bottom to its April 23, 2010, high, but sought safety in cash during any pullbacks.

If you're one of them, consider this: Since 1926, cash underperformed investment-grade bonds in 66% of all 84 one-year periods, and stocks nearly 68% of the time, according to Fidelity's Market Analysis, Research and Education Group (see chart below). Meanwhile, cash outpaced both stocks and bonds in just 12% of all those one-year periods.

So, ask yourself: Are you holding too much cash? Take the time to revisit your investment mix by using Fidelity's Portfolio Review¹ to help make sure your allocation to stocks, bonds, and cash is consistent with your risk tolerance, investment time frame, and overall financial situation.

Other fixed-income investors may be waiting for interest rates to rise to capture higher yields. Many look at today's low yields, currently about 2.05% for a five-year Treasury bond, and conclude it's hardly worth the effort to move their money out of a very liquid account to lock in such a low rate for such a relatively long time. But at least for the cash you won't need in the next three to five years, the cost of waiting too long in low-yielding accounts may be steeper than many realize—unless rates rise sharply and quickly.

Let's do the numbers

Imagine you have $100,000 to invest, and won't need it for five years. Let's say you kept that money in an extremely liquid investment like a money market fund earning 0.07%. After five years, assuming those rates rose 0.2 percentage points every six months, the $100,000 would be worth $105,580. If you factor in inflation, which is now about 2%, you'd actually be losing money.

Let's suppose, hypothetically, that the money is invested in a five-year Treasury bill, currently yielding 2.05%. If you sell it after holding it five years, it would be worth $110,736 (assuming interest is reinvested annually at 2.05%), enough to keep pace with inflation. But locking up your money for five years at such a low rate bugs you, since you think rates are more likely to rise than fall. (Of course, rates could also go down, but at such low levels currently, they don't have much farther to drop.) So, you leave the money in the savings account with the expectation that you'll shift into higher yielding securities when rates rise and potentially do better over the five-year period.

The problem is there can be a high cost to waiting.

As the table to the right shows, the only way to make money by waiting is if rates go up fast—and even then, you don't come out that much better (see shaded green boxes). For example, if interest rates jump two percentage points in a year, the $100,000 invested would be worth $117,733 after five years, $6,997 more than if you had invested immediately at 2.05%.

But how confident are you that rates will jump that far that fast? After all, the Federal Reserve has been holding interest rates low. Wait two years for rates to rise one percentage point, and the investment would be worth $110,577, $159 less than what you'd have earned if you had bought the hypothetical investment immediately. Wait three years for a one-point rate hike and the hypothetical investment is worth only $108,451, $2,285 less than with an immediate purchase of the five-year Treasury.

If rates don't go up, or they don't go up quickly, you may need to find increasingly higher yields just to generate the same 2.05% return as the five-year Treasury bill. As the graph below right illustrates, if you wait a year, you'd need a rate of 2.48% for the following four years to break even. That's not so implausible. But if you wait two years earning money market rates (which we assume increase 0.2% every six months), the break-even rate for the next three years on the Treasury yielding 2.05% goes up to 3.40%. At three years, it's up to 4.08%, and at four years, 6.67%.

As the graph shows, if you wait a year before investing in a five-year corporate bond, you'd need to earn 3.78% just to break even. Wait two years, and that rate goes to 4.81%. At three years, it's 6.68% and four years 11.89%. Of course, you are taking on more risk with a corporate bond than a Treasury bond.

Consider the alternatives

So what are your options for that longer-term cash that you won't need for three to five years? Like most things, there are trade-offs; in this case, a higher yield may mean lower credit quality as well as less stability and liquidity.

Want high liquidity and safety?

For high liquidity and safety, there are bank checking, savings, and money market deposit accounts. You can withdraw funds quickly. They can be insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per insured bank. And the value is stable. As of April 26, Bankrate.com reported that rates on money market deposit and savings accounts were averaging 0.672%. But that number includes teaser rates, so money held longer term in these accounts is likely to earn even less. Many checking accounts do not pay interest at all, though there are exceptions.

Or consider money market mutual funds, which are not insured or guaranteed by the FDIC or any other government agency. Money market funds are highly liquid, but generally stable. Though it is possible to lose money in a money market fund, it's rare. Over the 35 years they have been in existence, there have been only two instances of a money market fund "breaking the buck"—that is, paying less than $1.00 per share. But yields tend to track the Fed's target interest rate, which remains in a historically low range. The average retail taxable money market fund yield was 0.3% as of April 26, according to iMoneyNet.

Willing to trade less liquidity for potentially higher yield?

Consider short-term Treasury bonds, which are backed by the full faith and credit of the U.S. government. Yields are higher than for shorter-maturity instruments like savings accounts or money market funds, with the five-year Treasury at 2.05%. And you can sell these prior to maturity, though you may end up with less than the face value if interest rates on newly issued bonds have risen.

Another popular option: certificates of deposit (CDs). Bank-issued CDs are FDIC insured, and rates are relatively high: 1.71% for an average five-year CD as of April 26, according to Bankrate, though you can currently find them as high as 2.65%. But they cannot be redeemed prior to maturity without an interest penalty—generally six months' worth. Brokerage firms typically offer brokered CDs, which are deposits at a bank and FDIC insured. While there is no early redemption penalty, brokered CDs will incur a trading charge if sold prior to maturity.

Willing to take on even more risk?

Then you could consider investment-grade corporate bonds. Five-year AA bonds were yielding an average 2.968% as of April 26, according to Bloomberg. Of course, like Treasuries, these carry interest rate risk: if rates rise, prices of existing bonds fall. Corporate bonds also carry credit risk, the risk that the issuer will default and fail to pay coupons and principal as expected. If credit risk rises, the price of the bond in the secondary market would fall. So it's important to keep to very high quality bonds for this strategy.

With individual bonds, you can build a ladder of varying maturities, say, one to five years. That way, if rates rise, you can roll the maturing bonds into higher yielding ones, potentially increasing your total return potential. Of course, if rates fall, you would get lower rates on the new bonds, but you would have locked in the higher rates on the longer-term bonds. Use our online bond ladder tool to help create your own bond ladder by answering a few straightforward questions.

Or, consider a short- or intermediate-term bond fund where professional managers use laddering strategies to help smooth out income and total return potential. An added advantage of a bond fund: you get automatic reinvestment of interest, which is easy to forget when you are managing individual bonds but can add up over time. You also get professional management, diversification, and in the vast majority of cases, lower implementation costs. However, with a bond fund you don't own the bonds outright. If rates rise, the net asset value of the fund is likely to fall.

Likewise, high-bracket taxpayers might consider short-term municipal bonds or bond funds, where interest is free of federal taxes and, in many cases, state taxes too.

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