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When Rates on Short-Term Investments Are Higher Than Long-Term

When Rates on Short-Term Investments Are Higher Than Long-Term

March 20, 2024

A well-diversified portfolio contains various investment classes, including stocks, bonds, real estate, and alternative investments (annuities, commodities, gold, etc.) The movement in interest rates can impact all asset classes, but the portfolio's bond or fixed-income asset class will likely be the most sensitive.

Bonds and cash investments generally represent the conservative side of the portfolio. Bonds are IOUs by the issuer. The bondholder is obligated to receive interest payments twice a year and their principal back at the end of the term. Bonds include short-term and long-term obligations. Since interest payments will be made, we can classify CDs and Money Market funds as fixed-income obligations.

The average interest rate for a one-month of U.S. Treasury Bills from 2001 to 2022 was 1.5%, and for 2013 to 2022, the rate was a paltry .70% - not a significant contributor to portfolio growth in the past two decades. Today's current yields for most all short-term fixed-income investments are above 4.0% and some above 5.0%. Choosing between short-term and long-term bonds can be more challenging when short and long-term rates are equal or inverted.  

Below is a Yield Curve - a graph of separate treasury yields for separate bonds with different maturities. For example, on March 19, 2010 (green line), the yield on a 3-month Treasury Bill was .16%. Last Tuesday, it was 5.45%. 

 

The Yield Curve on March 19, 2010, was a typical yield curve that slopes upward. Lending money on a short-term basis did not earn higher returns than long-term because more risk is associated with longer-term borrowing. 
The Yield Curve on March 19, 2024, is called an "Inverted Yield Curve" since the slope is downward. It has happened before, and some believe it is a sure sign that a recession is coming, but the curve has been inverted since July of 2022, and the economy is not remotely close to entering a recession at this time.  


Short-Term Fixed Income/Bonds

* CDs
* Money Market Funds
* One Month to Two-Year U.S. Treasury Bills

Short-term fixed-income investments are typically relegated to stabilize a diversified portfolio or for those who are ultra-conservative or provide liquidity during times of needed cash. A benefit to holding short-term investments today is the ability to earn a reasonable inflation-beating return for funds set aside for short-term goals, such as plans to buy a house, etc. Usually, the funds needed for shorter-term goals would not be invested in stocks and other higher-risk assets because of the increased risk of short-term losses associated with longer-term investing. Shorter-term fixed-income investments contain less risk than longer-term bonds since longer-term bonds factor in rising inflation risks, the risk of default on payments (corporate or municipal) and principal repayment, and the risk of rising interest rates.

The main drawback to investing greater amounts in shorter-term instruments is when rates eventually fall, especially quickly, the longer-term bonds will continue to pay higher yields while the reinvesting of short-term vehicles will pay the new lower rates.

 

Longer-Term Bonds/Fixed Income

* Intermediate (3 to 10 years) US Treasury Bills
* Long-Term US Treasury Bonds (> 10 years)
* Corporate Bonds
* Municipal Bonds

 A fixed-income instrument plays three primary roles in a portfolio: to serve as a liquid reserve in emergencies, to generate a stable cash flow, and to provide the portfolio with stability, allowing investors to take equity risk. A typical stock-to-bond allocation of 60/40 means that 40% of the portfolio is invested in conservative investments, including short-term and long-term fixed-income investments.

From 2001 through 2022, Bloomberg’s Aggregate Bond Index (a weighted average measurement of all bonds, including short-term, long-term, government, municipality, or corporate) was 3.7%. Today, the yield on even the safest and shortest maturity (One-Month U.S. Treasury Bill) is 5.4%.

Two significant benefits are working in the favor of longer-term bonds right now:

  • Longer-term bonds can pay the current higher yields for a more extended period than a CD or a money market fund. You could “lock in” long-term yields between 4.0% and 5.5%, which can provide growth in the conservative side of the portfolio that may outpace longer-term inflation. Overall portfolio returns can be much higher if equities attain their traditional expected returns. Bonds can be purchased individually or through a Mutual or Exchange-Traded fund. The benefit of purchasing individual bonds is the ability to select the coupon payment and the length of the term, which allows for “laddering” of maturities. See below for the benefit of Bond funds.

  • The Aggregate Bond Index¹ bond index lost 13.0% in 2022, and Long-Term Government Bonds² lost 26.1% in value during 2022. Why am I listing this as a benefit? The losses were largely due to the rapid interest rate increases, which should reverse itself when rates eventually fall. Today, most bond funds are still being carried at unrealized losses because of it.
    Unless inflation runs rampant, the current rates should eventually fall since it is doubtful our economy can sustain the impact that continued high mortgage rates could have on a long-term basis. When interest rates eventually fall, the values of the longer-term bonds should increase with each rate reduction. New purchases will take advantage of the capital gain appreciation due to the eventual fall of interest rates. The interest payments will still be taxed as ordinary income.   

    ¹ Data provided by Bloomberg
    ² Data provided by Ibbotson Associates via Morningstar Direct         


We are an Independent Fiduciary. We take pride in helping our clients make better informed financial decisions. Allocating portfolios based on your circumstances requires knowledge of various financial areas. The opportunities today with existing interest rates can help improve the chances of attaining your financial goals. Please feel free to contact us (925-484-1671) to schedule an appointment or if you have a question.


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