Now, many of those CDs and other short-term vehicles that investors have put their cash into are maturing, and owners face the question of what to do next.
Should they stay in short-term investments or is it time to look at ways to help meet their investment needs with longer-maturity bonds? Answering that question is now more urgent because the Fed is widely expected to cut rates in September.
What is risky about short-term investments?
While short-term investments are great for maintaining liquidity and flexibility and avoiding the risk of losing money in a market downturn, they are not risk-free. Having too much of them creates its own risks. Possibly the greatest of these risks is that a portfolio with too much in short-term positions won’t earn enough over the long term to stay ahead of inflation.
Historically, when the central bank has cut rates, yields on places to store short-term cash have also come down. That means that those attractive interest rates on money market funds will also come down. It also means when the short-term CDs and bonds you now own mature, you may be unable to find new ones that pay as much as the old ones did. This is called reinvestment risk.
If not short-term investments, then what?
Fortunately, you do have an alternative to watching lower interest rates eventually reduce your portfolio’s ability to generate the income you need, and it does not have to involve investing in stocks. Longer-maturity investment-grade bonds issued by companies with high credit ratings and by governments have historically delivered higher returns than either short-term investments or stocks when the economy is slowing and interest rates are no longer rising. By investing in bonds with maturities of between 3 and 10 years you can avoid the risks posed by holding too much in short-term investments, and instead potentially continue to earn the level of return you seek from your portfolio.
What happens to bonds, cash, and interest rates in a slowdown?
When the economy slows, central banks typically cut interest rates in hopes of stimulating an economic recovery, and yields on money market funds and other short-term cash destinations come down. While yields on newly issued bonds will eventually also come down along with rates, the interest, (or “coupon”) that a bond pays remains unchanged until the bond matures or is redeemed by its issuer. That makes it possible for investors in longer-maturity bonds to enjoy today’s relatively high yields well into the future, even after rates come down and short-maturity investment returns suffer. In fact, bonds are the only asset class since 1950 to produce double-digit gains during recessions, providing ballast against equity market declines.
Bond yields follow interest rates, and they also move in the opposite direction of bond prices. That means when rates and yields come down, as they are likely to if the economy slows, bond prices are likely to rise. Because the total return that a bond delivers to its holder is a combination of the coupon yield and any changes in the bond’s price, the combination of potential rising prices in the future and relatively high yields in today’s market could deliver returns that are significantly greater than those available on short-term investments.
Keeping your balance
Another potential risk that comes from not reinvesting your maturing short-term investments into longer-term bonds stems from the fact that short-term positions have historically not provided as much protection as bonds from the declines in stock prices that often take place during economic slowdowns. In recessions, it is not unusual for stocks to decline by double-digit amounts. But when stocks have historically sunk, bond prices have often risen by double-digit amounts. While short-term positions did not lose value like stocks during those periods, they also did not gain in value like bonds, which means that the overall value of an investor’s portfolio was more likely to be pulled down by sagging stocks if they had too much in short-term positions and not enough in bonds.
Time to move?
To be sure, CDs and other short-term fixed income investments still look attractive right now. The U.S. economy continues to grow and is not in recession. However, inflation has diminished, some indicators of economic activity are signaling a slowdown, and the Fed looks increasingly likely to cut rates in September. So while it is nearly impossible to pick the perfect moment to reinvest your cash proceeds into bonds, investors who stay in short-term investments may risk missing their opportunity.
