This video was updated February 2024 while the rest of the article was published in July 2023
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!
IMPORTANT DISCLOSURES
The information and statistics contained in this communication have been obtained from sources we believe to be reliable but cannot be guaranteed. Any projections, market outlooks or forecasts discussed herein are forward-looking statements and are based upon certain assumptions. Other events that were not taken into account may occur and may significantly affect the returns or performance of these investments. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. These projections, market outlooks or estimates are subject to change without notice. Please remember that past performance may not be indicative of future results.
Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product, or any non-investment related content, made reference to directly or indirectly in this communication will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. No discussion or information contained herein serves as the provision of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability above to his/her individual situation of any specific issue discussed, he/she is encouraged to consult with the professional advisor of his/her choosing. City Different Investments is neither a law firm nor a certified public accounting firm and no portion of this content should be construed as legal, tax, or accounting advice.
Opinions and statements of financial market trends that are based on market conditions constitute our judgment and are subject to change without notice. Historic market trends are not reliable indicators of actual future market behavior. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved and may be significantly different than that shown here. The information presented, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable, they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. The Firm assumes no duty to provide updates to any analysis contained herein.