There is a cost to waiting for interest rates to rise—you may be missing out on higher coupon rates and yields elsewhere. Rather than waiting on the sidelines for yields to rise, investors should consider short-term corporate bonds today—specifically those with fixed coupon rates.
Short-term corporate bonds offer higher yields than many other short-term alternatives
It might be tempting to hold investment funds in cash or cash-like investments, such as money market funds, while you wait for interest rates to rise. While cash always has a place in well-diversified portfolios, we caution against holding cash as a proxy for fixed income, as it is a potential drag on total returns.
To be clear, we are not suggesting investors shift their traditional cash positions, like those needed for daily liquidity or near-term expenses, into short-term, fixed-rate corporate bonds. Rather, we’re targeting funds that would or should be allocated to fixed income, based on an investor’s strategic asset allocation mix, but instead is sitting in cash because bond yields are so low. Short-term investment-grade corporate bonds come with higher risks than cash or money market funds, like more credit risk and interest rate risk, but overall those risks are relatively low.
Short-term investment grade corporate bonds offer a yield advantage over Treasury bills
Source: Bloomberg, as of 10/5/2021. Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index), Bloomberg U.S. Treasury 1-5 Year Index (LTR1TRUU Index), Bloomberg U.S. Floating-Rate Notes Index (BFRNTRUU Index) and the Bloomberg U.S. Treasury Bills 1-3 Month Index (LD12TRUU Index). Past performance is no guarantee of future results.
For those tactically waiting for rates to rise before investing in bonds, there is a cost to that strategy: the opportunity cost of compounding the higher yields that are available today in other high-quality investments. While the yields shown above are low by historical standards, the nearly 1% yield advantage that investment grade corporate bonds offer over short-term Treasury bills can’t be ignored.
In this example below, note that the column on the right assumes a 1% interest rate in just one year, which is still well below market expectations of where the federal funds rate likely will be at that time.
There is a cost to waiting for rates to rise
Source: Bloomberg. Hypothetical scenarios using the yield on a 3-month Treasury bill of 0.05% and the yield-to-worst of an average 3-year corporate bond of 1.0%. The third scenario assumes the Fed funds rate is increased to 1% in year two, resulting in 3-month Treasury bill yield of 1.0%. For illustrative purposes only.