In the evolving landscape of cash and fixed income markets, interest rates have risen significantly in recent years, leading to short-term rates surpassing long-term rates (inverted yield curve). This scenario often prompts the question: “Why not invest everything in a money market fund or Treasury Bills (T-bills) right now?” The answer could come down to marshmallows.
In 1970, psychologist Walter Mischel conducted a study on delayed gratification where children could choose one immediate reward or wait to receive two rewards. The concept can be applied to investing: focusing solely on money market funds or T-bills might be like opting for the single marshmallow, whereas a diversified approach with a cash allocation and also investments elsewhere, could yield greater long-term benefits, akin to waiting for two marshmallows.
Understanding cash allocation yields
The rise in yields has been a result of Federal Reserve rate hikes, inflation, and economic growth. However, rather than dwelling on the past, let’s focus on future strategies:
- Optimize Your Fixed Income Allocation: Generate interest income by leveraging the current interest rate environment for both short-term and longer-term investments (two marshmallows).
- Implement Tax-Efficient Strategies: Maximize your after-tax yield by considering the tax implications of different fixed income investments.
The inverted yield curve and investment choices
With an inverted yield curve, short-term yields exceed long-term yields, tempting many to invest heavily in money market funds and T-bills. However, economic conditions and Fed policies are always changing, which makes predicting future rates challenging. Because of this, it is important to have a fixed income investment strategy rather than only being invested in money market funds and T-bills and opening yourself up to reinvestment risk when interest rates decline.
The inverted yield curve suggests that investing in longer-dated bonds now could sacrifice near-term yield but lock in higher income over time as interest rates potentially decrease with future Fed cuts. It’s essential to recognize that different types of bonds are influenced by various factors, not just Fed policy.
It is also important to note that the media consistently reports on Fed policy and the short-term interest rate they set as ubiquitous to all rates. As we know from the concept of a yield curve, there is more than one rate, and these other rates can be influenced by factors other than Fed cuts. Money market funds and T-bills are driven by Fed policy, while intermediate term notes (5-10 years) and long-term bonds (10+ years) are generally driven by economic expectations.
Insights to action
Higher interest rates mean higher yields on assets. There are a variety of distinct asset classes and solutions available to capture these yields:
- Low-Risk / Short-term Options: Money market funds and T-bills can offer secure returns.
- Longer-Dated Bonds: Intermediate or longer-dated treasury, corporate, and municipal bonds can provide stable returns over time, albeit with additional risks including credit and/or interest rate risk.
- Higher-Yielding Opportunities: For accredited investors willing to accept more risk and less liquidity, private credit can offer significantly higher yields.
Risks for you to consider
Over-allocating to cash: Holding more cash than your financial plan suggests can lead to missed opportunities in other asset classes. This compounding of opportunity cost can impact long-term returns and financial goals.
Reinvestment Risk: When the Fed cuts rates, reinvestment risk becomes a concern for those with heavy cash allocations.
Tax treatment can vary; focus on after-tax yield
The after-tax yield is crucial when evaluating fixed income investments. Different asset classes have varied tax treatments, and where you hold these assets (brokerage vs. tax-sheltered accounts) can affect your net returns. Here’s a brief overview:
| Asset Class | Opportunity | Risk | Tax |
| Money Market Funds
|
Daily liquidity with no market movement. | Interest rates can adjust quickly. | 1099, income is dependent on underlying positions within the fund. |
|
Treasury Bonds
|
Lock in interest rate for a set maturity. Treasuries are considered the safest and most liquid bonds. | Increase in interest rates can result in a loss if sold before maturity. | 1099, income is taxed at ordinary rates federally but exempt from state and local income taxes. May also have capital gains. |
| Municipal Bonds
|
Lock in interest rate for a set maturity, usually exempt from federal income tax, and may be exempt from state and local income tax. | Increase in interest rates can result in a loss if sold before maturity.
Credit risk from issuer. |
1099, income is usually exempt from federal income taxes. Income might be subject to taxation if issuer is from another state. May also have capital gains. |
| High Yield Municipal Bonds | Potential to earn higher interest rates than municipal bonds that is usually exempt from federal income tax and may be exempt from state and local income tax. | Increase in interest rates can result in a loss if sold before maturity.
More credit risk from issuer than municipal bonds. |
1099, income is usually exempt from federal income taxes. Income might be subject to taxation if issuer is from another state. May also have capital gains. |
| Corporate Bonds
|
Earn potentially higher interest rates from comparable U.S. Treasury bonds with similar maturities. | Increase in interest rates and spreads above treasuries can decrease bond price or cause losses if sold before maturity.
Credit risk. |
1099, income is taxed at ordinary rates federally. Income is subject to state and local income taxes. May also have capital gains. |
| High Yield Corporate Bonds | Earn higher interest rates above corporate bonds. Can potentially benefit if company credit rating improves during holding period. | Increase in interest rates and spreads above treasuries can reduce gains or cause losses if sold before maturity. Rapid increase in spreads can occur during times of market volatility causing decrease in bond price. | 1099, income is taxed at ordinary rates federally. Income is subject to state and local income taxes. May also have capital gains. |
| Private Credit open only to accredited or qualified investors | Much higher interest rates than public bond markets. | Illiquid, can be difficult for inexperienced investors to understand, and typically make concentrated investments in only a handful of companies. | K-1, income is taxed at ordinary rates. May also have capital gains. |
Be patient and earn two marshmallows
Patience and strategic planning are key to help maximize potential returns. Don’t try to time the market by being overly invested in money market funds and short-term T-bills for your fixed income allocation. Match your cash allocation with short-term cash flow needs and consider investing more in intermediate and longer-dated fixed income per your financial plan. Don’t forget to consider the taxability of your investment income when deciding on the appropriate fixed income allocation. And, most importantly, talk with your financial advisor about the right fixed income allocation for you based on your unique situation and goals.
