These are exceptionally challenging times for income investors. While the Federal Reserve (Fed) has raised short-term rates gradually from the historically low levels reached during the global financial crisis, investors are still challenged to balance their income and liquidity goals.
Finding balance in an unbalanced market
Fearful of continued market volatility, investors still have significant holdings in ultra-conservative investments, parking their money in low-yielding U.S. Treasurys, money market funds and bank deposits. But this strategy presents its own risks — namely that the low yields these investments offer will make it difficult for investors to meet their financial and personal goals.
Fortunately, the tiering of fixed income investments according to liquidity may provide a flexible solution, helping to satisfy the short- and intermediate-term needs of investors while putting their assets to work in more effective ways.
How safe is safe?
During the financial crisis, the Fed cut the target federal funds rate, a key benchmark for short-term interest rates, to a record low range between 0.00% and 0.25%. The Fed’s goal was to help pull the U.S. economy out of its deep recession, with the expectation that once the economy stabilized, rates would return to more normal levels. The process of interest rate normalization began in December 2015 with a 25 basis point increase to its federal funds target rate. To date, the Fed has hiked the fed funds rate six times to 1.75% — still below its long-term inflation target of 2%.
Fast forward nine years and yields of securities maturing in one year or less are still below where they were at the start of the financial crisis. Despite having attained its target for unemployment and nearly so for inflation, the Fed remains cautious in its approach to interest rate normalization, although there are some signs this could change under new Fed Chairman Jerome Powell.
In fact, as Figure 1 demonstrates, yields on short-term securities remain at levels below long-term averages. For example, in 2007, the three-month U.S. Treasury Bill yielded more than 5.00%. Today, that same Treasury yields 1.72%.1 In real terms, this means a $100,000 investment would have generated annual income of over $5,000 in 2007, compared to less than $1,750 today.
While the equity market hovers near all-time highs, many investors continue to be far more concerned with principal protection and liquidity than yield. However, limiting a portfolio to cash, money market funds and U.S. Treasurys presents its own risks — as previously stated, investors may be locking in yields that are too low to meet their larger financial goals or to keep pace with inflation.
Putting fixed income portfolios to work now
Fortunately, there are tax-exempt, short- and intermediate-term fixed income investments that may offer more attractive yields without undue risk. These investments typically either have slightly lower credit ratings or longer maturities than money market funds and other traditional cash holdings.
Generally speaking, the lower the credit quality, the greater the yield spread relative to a higher quality credit. Similarly, when two fixed income investments have different maturity dates, the one with the longer term typically will pay a higher yield. Figure 2 on the next page illustrates that by both extending out maturity dates and/or investing in lower quality bonds, investors can be rewarded with higher yields. The gray line shows the various yields for AAA rated tax-free municipal bonds at various maturity dates. The blue line illustrates the yields for a lower quality A-rated tax-free municipal revenue bond with the same maturity dates.
With the Fed actively tightening monetary policy, many investors are growing increasingly concerned that interest rates and inflation have nowhere to go but up. As a result, they are reluctant to venture beyond cash deposits and other investments that offer daily liquidity. But remember, there is an opportunity cost to limiting a portfolio’s exposure to only the shortest and most liquid securities.
For retail investors, the average tax-free money market fund’s seven-day yield is approximately 0.86%. For comparison, a one-year AAA rated tax-free security offers a yield of 1.55% and a five-year is yielding slightly over 2%, as of March 29, 2018. Investors who are willing to take on a little more principal volatility may be able to boost their overall portfolio income by moving out slightly on the yield curve.
Why duration matters
Gauging the risks posed by rising interest rates isn’t an easy task, even for financial professionals. In general, as interest rates go up, the value of debt securities goes down. How much so?
Duration, which is typically expressed in years, measures an investment’s sensitivity to rising or falling rates and is an important tool investors use to evaluate their exposure to interest rate risk. The rule of thumb is that for every one percentage point increase in yields, an investor can expect to lose an amount equal to the fund’s duration.
This means that if interest rates rose 1%, investors in a bond fund with duration of five years could see their principal value fall as much as 5%, before considering the income they would receive. Duration matters less for investors in shorter maturity investments. That’s because the shorter the average time to maturity, the less sensitive the fund’s value to interest rate changes.
Enhancing returns by liquidity tiering
The decision of whether to reach for yield by moving down the credit-ratings ladder or stepping out on the yield curve depends largely on an investor’s risk tolerance and their liquidity needs. For example, if cash is needed to cover everyday expenses, it makes sense to focus on low-risk money market funds and cash deposits that offer a constant net asset value. Conversely, if cash is intended to fund longer-term needs, such as college tuition in five years, an investor may be able to ride out some degree of short-term volatility in exchange for a higher yield.
As shown in Figure 3, liquidity tiering is a simple framework that can help investors create more effective fixed income portfolios by allocating their assets into four distinct segments based on their short- and intermediate-term requirements. Each tier becomes progressively more aggressive, allowing investors the opportunity to increase their overall return while maintaining a measure of stability and liquidity in historically conservative positions.
Tier 1: Operating cash
The purpose of the first tier is to meet immediate day-to-day cash needs. These funds should be invested in traditional money market strategies and/or FDIC-insured bank accounts to help ensure capital preservation and daily liquidity.
Tier 2: Core reserve cash
The aim of the second tier is to provide liquidity for ongoing spending needs. Tier 2 assets still should be invested conservatively; however, moving a step further out in duration opens the door to investment in high-quality debt with maturities beyond one business day, such as an enhanced cash or an ultra-short bond fund, that can potentially enhance yield and better match intermediate cash liabilities.
Tier 3: Short-term assets
The third tier consists of assets intended to help meet spending needs a year or more into the future. This portion of the fixed income allocation could be invested in short-term and low duration bond strategies to provide a higher potential return while maintaining principal preservation.
Tier 4: Strategic assets
Finally, the fourth tier consists of assets intended to meet longer-term needs. Tier 4 assets could be invested in an intermediate-term fund, which may provide an attractive trade-off between interest rate risk and the potential for higher returns.
The advantage of a liquidity perspective
The management of cash to meet spending needs has grown more complex since the last recession. How can investors maximize the income available from their bond portfolio in today’s low-rate environment while remaining well positioned for whatever comes next?
An experienced financial professional with access to cash management expertise can show you a more effective approach to managing your fixed income portfolio by helping you to match your holdings with your liquidity needs. Equally important, they can help you select an investment management team that has successfully managed cash and bonds across market cycles — one that offers a choice of actively managed solutions to help boost the effectiveness of your portfolio while striving to mitigate the risks of today’s uncertain markets, including
- Tier 1: Operating cash solutions, such as BMO Tax-Free Money Market Fund, that provide daily liquidity to meet current needs.
- Tier 2: Core reserve cash solutions, such as BMO Ultra Short Tax-Free Fund, that use a slightly longer duration to enhance yield. Because the BMO Ultra Short Tax-Free Fund focuses on high-quality municipal issues, the current income it provides is also largely exempt from federal income tax.
- Tier 3: Short-term asset solutions, such as BMO Short Tax-Free Fund, that seeks to maximize total return consistent with current income by focusing on intermediate-term investment grade bonds and notes.
- Tier 4: Strategic asset solutions, such as BMO Intermediate Tax-Free Fund, that seek to provide a high level of current income that is free from federal income taxes, consistent with preservation of capital by focusing on high-quality municipal bonds.
Each of these funds benefits from active management of credit, duration and sector positions, enabling them to take advantage of structural opportunities that currently may exist in the municipal market. These short-term and low duration strategies have potentially higher yields because they invest in securities with slightly longer maturities and lower credit ratings than money market strategies.
The fixed income markets are always changing. With a diversified portfolio allocated according to liquidity needs, investors have the potential to achieve an optimal balance between stability and yield, regardless of market conditions.
Past performance is no guarantee of future results.
All investments involve risk, including the possible loss of principal.
An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in these funds.
U.S. Treasurys are backed by the full faith and credit of the U.S. Government, whereas mutual funds are not.
Bank and thrift deposits are insured by the Federal Deposit Insurance Corporation (FDIC). Credit Union deposits are insured by the National Credit Union Administration.
1Daily Treasury Yield Curve Rates. U.S. Department of the Treasury Resource Center. www.treasury.gov.
Interest income from Tax-Free Fund investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes.
Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a Fund’s portfolio.
Lipper Tax-Exempt Money Market Funds category average is an arithmetic average of the total return of all tax-exempt money market mutual funds tracked by Lipper.
The Barclays Municipal Bond 1 Year Index is the 1- to 2-year component of the Barclays Municipal Bond Index.
iMoneyNet Money Fund Report Average™ is an arithmetic average of performance for all money market mutual funds tracked within this category. Money Fund Report Average™ is a service of iMoneyNet, Inc.
Diversification does not ensure a profit or protect against a loss in a declining market.