Cash is no longer trash, but investors hoping to get out of money market funds and into other assets like stocks and bonds in time for the Fed to cut interest rates may be regretting not acting sooner.
Playing it safe doesn't necessarily mean just holding money market funds or government bonds. “There are other ways to maintain higher quality and earn more basis points than money market funds,” says Jerome Schneider, portfolio manager and head of short-term and low-duration portfolio strategies at Pimco. He compares a typical money market fund, which returned about 5.1% in 2023, to an ultra-short-term bond fund, which has a total return well over 6%. Ultra-short-term bond strategies (investing in high-quality corporate bonds, asset-backed securities, etc. with maturities of 0 to 1 year) can achieve higher returns with some interest rate exposure, price appreciation and spread income.
This is a somewhat aggressive cash management strategy that allows for price appreciation that money market funds don't get when the Fed cuts interest rates.
Even if the Fed doesn't cut rates tomorrow, it's likely to do so later this year, Schneider said. “Investors should prepare for that by exiting cash and money market strategies, moving the yield curve slightly outward and targeting price appreciation with defensive asset allocations,” he said.
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Investors have been especially enthusiastic about money markets since they rose above 5% in August 2023. Money market mutual fund assets are down to $6.98 trillion after rising over the past eight weeks, but are still expected to grow by $212 billion, or 4.5%, through June 18, 2024, according to the Investment Company Association.
Market participants have been waiting with bated breath for the Federal Reserve to cut interest rates since early 2024. Brett Horowitz, principal at Evensky & Katz/Foldes Wealth Management, says some clients have told him they will sell high-yield money-market funds and return to traditional bond and stock funds if interest rates on cash equivalents fall after the Fed's first rate cut.
But investors have historically tended to hang on to money-market funds and similar vehicles for longer than necessary, Schneider said. While some institutional investors extend the yield curve in search of further price appreciation as soon as the Fed starts cutting rates, retail investors tend to do so a year to 18 months after the rate-cutting cycle begins.
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“Investors haven't necessarily acted as quickly as they should,” Schneider said. The market currently expects the Fed to cut interest rates six times through 2025. Assuming a 25 basis point cut each time for a total of 150 basis points, “that's a loss of revenue in terms of price appreciation,” he said.
When interest rates fall, bond prices rise. In contrast, money market funds' yields fall, but their prices do not rise.
Investors with a bit more risk tolerance can lock in the current 4.7% yield by looking a rung or two up the fixed-income risk ladder into short-term investment credit or short-term two- to three-year Treasuries, says Daniel Slick, global head of short-term liquidity and portfolio manager at Janus Henderson. While it might not be as good as the 5% yield on a money-market fund, a one-percentage-point increase in yields would mean a 1% to 2% increase in principal against that coupon rate, he says. That's because lower yields also mean higher bond prices, something investors can't achieve with cash.
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“Now is the time to predict where the puck is going, not where the puck has been. Investors need to stop thinking like that,” Slick said.
Too much emphasis on cash interest rates
Compared with yields of less than 1% on savings and checking accounts at many banks, money market funds offer little room for error.In fact, much of the inflow into money market funds over the past year has come from consumers frustrated with meager interest rates on their bank accounts, says Peter Crane, CEO of Crane Data, a money market and mutual fund information company.
Still, many of Horowitz's clients can't help but compare the guaranteed interest rates of the money-market funds in their portfolios to the bond funds, “leading them to question why they have the bond funds in the first place,” he said. “This, too, is shortsighted, because if interest rates fall, the bond investments in their portfolios will rise in value because of their longer duration and maturity.”
Investors may not want to hear it: It was a terrible time to hold bonds.
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The iShares Core US Aggregate Bond ETF is flat so far this year and down 3% over the past three years, disappointing investors who were hoping that the Fed's interest rate cuts would boost bond prices earlier this year.
“Bonds are the only positive carry hedge in the business cycle,” Sulik says. “If yields fall, you get yield and potentially capital prices rise.”
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