It appears as though we’re in a wait and see mode to determine what’s next for the direction of interest rates. The Fed has come off its previous notion of 3 rate cuts this year to perhaps one. What is interesting is that you don’t hear conversation about monetary tightening anymore or raising of the Federal Funds rate, as inflation has probably peaked, and is hopefully heading down to the Fed’s two percent target. As such, this is a moment to catch our breaths and look for places to invest while yields stay around there current high-end levels. The chart below shows the effective Federal Funds rate, which hasn’t been this high in twenty years.
We’ve come accustomed to not thinking about receiving interest on our savings accounts or other near-cash holdings, as it’s been some twenty years since its mattered. The average American with average savings isn’t going to go out of his or her way to move money around for a basis point or two. That has all changed since we’ve moved on from essential zero interest rate yield to the five plus percent where we are today. What is surprising is that many have still not gotten on board the yield train and are passing up what amounts to sizable interest. According to the Federal Deposit Insurance Corporation (FDIC), about $17.5 trillion sits in commercial banks, where the average savings account earns 0.45% in interest a year.
If you were one who kept your savings in a traditional bank or under the mattress you suffered a double whammy. First, the opportunity cost of not being invested in a 5% online savings account, money market or Treasury bill. Second, if you were getting that less than outstanding average of 0.45% a year, you have been losing money to inflation that has been much higher than that. If you’re in that boat you’re not alone. According to a Santander Bank survey of more than 2,200 adults published in May, 21% of Americans who save don’t know how much interest they are earning on their savings accounts. Chances are if you don’t know what you’re earning you’re not gonna move it.
We understand the need for liquidity, when only cash will do. Unexpected house repairs, car troubles, taxes and the like all bode well for the need for keeping a cash cushion. What many Americans have done, young and old, is utilize money market funds to gain some of the best yield out there with very little risk. As you can see from the following chart, money flow into money market funds has reached all-time highs.
If you have investable cash other than that needed for liquidity, going outside of the money market world can give you other options. Bonds in particular, whether they be federal, municipal or corporate give you added income with varying amounts of risk. According to Allison Walsh, senior vice president at Income Research + Management in Boston, “Bonds offer a compelling value proposition for investors at current yield levels, which are the highest in more than 15 years.”
When looking at bonds an effective strategy can be what is known as a bond ladder. We’ve gone into detail on this strategy at Investing and Money in the past, where you buy bonds over a set period of time with different maturities. The ladder has bonds that typically mature every year, freeing up cash to invest in another bond with a longer maturity date. According to Timothy Wyman, a certified financial planner and lawyer in Southfield, Mich., “Just as you wouldn’t move all your assets into equities at once, you want to dollar-cost-average into bonds.” The duration and quality of the bond ladder will be dictated by your risk and how long you want to tie up that cash, among other things.
If you’re not thrilled about buying individual bonds, bond ETF’s could be for you. If you got into bond ETF’s several years ago before interest rates started rising you’re probably kicking yourself now. Remember there is an inverse relationship between price and interest rates. We’ve seen draconian rate rise in the past several years resulting in lower bond prices making the value of the bond ETF’s holding them fall. However, if you’re so inclined to think that rates might be falling, all other things being equal, now would be the time for bond ETF’s. The longer the maturity of a bond, the more sensitive it is to changes in interest rates. This is because the longer the bond has to run, the more time there is for interest rates to change. As a result, long term bond ETF’s tend to perform better than short term bond ETF’s when interest rates fall.
Another option is high-yield bonds, which are bonds that are issued by companies with lower credit ratings. These bonds are more sensitive to changes in interest rates than investment grade bonds, which are issued by companies with higher credit ratings. As a result, high-yield bond ETF’s tend to perform better than investment-grade bond ETF’s when interest rates fall. Municipal bonds are also a great choice for investors in a high-tax bracket in a high-tax state. Every municipal bond is free of federal tax and some are triple tax-free, exempt from federal, state and local taxes. According to Bill Harris, a former chief executive of PayPal and founder of Evergreen, a digital wealth-advisory firm, “From purely a tax point of view, munis are the best there is for higher-income taxpayers.”
Take your pick, but don’t take too much time. With the Fed likely to cut rates this year we may be at the top of the yield curve in regard to interest income going forward.
