5.5% seems like a pretty great investment return for cash-equivalent instruments. Given how low the risk is for a CD or money market funds, taking the 5.5% and running seems like a solid bet right now. But is it actually?
Cash Trap from City Different Investments on Vimeo.
Maybe not. Not on its own, anyway.
The Fed Funds Rate is a good proxy for overall short-term interest rates. And if you look at our recent history, the reinvestment risk can be heavy if you park your money in a short-term interest product.
When it comes to Fed Funds rates, the old proverb applies — “what goes up must come down” … and often quickly.
For example, on Jan. 1, 2001, the Fed Funds rate was 5.98%. By Oct. 1 of that same year, it was 2.49% — a 58% decrease in 9 months!
That’s textbook reinvestment risk. You could have earned markedly greater returns on your money over that time period by hedging against rate reductions (either by extending maturity durations or putting some cash into alternative investment vehicles).
Furthermore, investing in short-term fixed-income instruments (e.g. money market funds) has become a “crowded trade.” When investors are moving like a herd, returns diminish as the herd moves into a specific instrument. But when the herd begins leaving that instrument… the instruments they move to become more expensive.
One way to hedge against reinvestment risk is to extend the maturity (duration) of your investment at the preferential/higher rate. This can be accomplished by combining a money market fund with longer maturity investment-grade bonds in a separately managed account (SMA). This changes the underlying risk profile marginally, but you can lock in that higher rate for a longer period of time.
This strategy provides a slew of benefits:
1. Time gives investors optionsA slightly lower dividend stream with less rate fluctuation can be a better investment option in the long run. If you pair money market funds with investment-grade bonds in an SMA, you preserve a higher rate for longer, and increase your flexibility throughout the duration of both.
2. Reverse disintermediation riskWhat happens when the herd reverses out of money market funds (aka reverse disintermediation)? Well, all the other options get more expensive!
3. First mover advantageWhen it comes to first mover advantages, investing can often be like technology companies. For a tech company, getting a mature product to market first can often corner that market before competitors can elbow into it. The same can be true of investing; if you are a first mover away from what the herd is doing, you can purchase alternative instruments for less money — meaning more room for growth — than if you wait for the herd to do the same thing eventually.
If you'd like to get more specifics on how this strategy might benefit you, or have any questions, please feel free to reach out to Sweta or me. We head the fixed-income desk at CDI, and would love to speak with you directly!
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