Money Market Fund vs. Bonds: Which is Better?

Bond Concepts by Madison Investments

Second Quarter, 2023

As the Federal Reserve (Fed) orchestrated a historic increase in interest rates to combat inflation, fixed income investors finally saw income return to their portfolios. The 10-year Treasury bond, which yielded 0.6% in August 2020 had surpassed 4% by October 2022. As interest rates rise, bond prices fall, and the rapid rise in interest rates brought with it significant portfolio revaluations. The 0.6% yield proved insufficient in buffering the rate increase, and many investors saw double-digit negative returns in 2022. But with the Fed indicating its tightening cycle may be nearing an end, we believe much, if not all, of that negative performance is behind us.

Many investors, as indicated by the Fed Funds futures markets, believe the next move in rates will be down, possibly by the end of this year. With the potential for an economic slowdown and uncertainty in markets, the essentially risk-free asset of cash is tempting many investors with yields that have not been available in 15+ years. Some may be questioning the role of fixed income when cash can yield the same amount or more.

Having experienced the impact of interest rates rising, let’s examine what investors may face if rates move in the other direction. Understanding this phenomenon is essential when deciding whether to invest in cash or bonds. Let’s start with the basics.

The basics: Money Market and Bond Funds

Cash–including money market funds, high-yield savings accounts, and short CDs–and bonds are all perceived to be relatively “safe” investments, but differ in terms of their risk level and return potential. Cash is the least risky of the three but offers the lowest potential return. Money market funds are a type of mutual fund that invests in short-term, low-risk securities such as treasury bills and commercial paper and offer a slightly higher return than cash. Bond funds invest in various fixed-income securities with varying maturities and credit ratings and offer a higher potential return than money market funds but also come with greater risk.

Short-term bond funds typically invest in bonds with maturities of five years or less. Intermediate bond funds invest in bonds with maturities out to ten years, while long-term bond funds can invest in bonds with maturities of thirty years or more. Longer-term bonds are more sensitive to interest rate movements than short-term bonds. Interest rate risk is measured by a bond’s duration.

Duration

Duration is a measure of the expected change in a bond’s price for a given change in yields. When interest rates rise, duration becomes a tangible measure of a bond’s decrease in value. However, duration also offers the potential for capital appreciation. When interest rates fall, the price of a bond increases, leading to capital gains for investors should they decide to sell the bond before maturity. The greater the duration, the greater the price appreciation (falling rates) or depreciation (rising rates). If an investor anticipates interest rates will fall, having exposure to longer-duration securities like bonds can provide a bump for the return of a portfolio. With cash and money market funds, if interest rates fall, there is little opportunity for price appreciation.

Income +/- Change in Price = Total Return

The total return on a bond or portfolio of bonds is a function of the income it generates plus or minus any change in price. For most bonds, the level of income a bond will provide is set when it is bought. It is simply the coupon adjusted for the price paid for the bond. Change in price is a function of the duration of a bond (described above) and the amount of change in the bond’s Yield to Maturity (YTM). The total return potential in today’s market is far more appealing for bond investors than just a short time ago when interest rates were low and credit spreads were tight. It is quite common for a high quality, intermediate bond portfolio to offer a starting YTM well over 4% today versus under 1% just a few years ago.

As the illustration below shows, the current, higher yield environment adds value whether rates rise or fall. If rates rise, the higher level of income acts as a cushion, offsetting some of the expected price decline. If rates fall, having some duration in a portfolio provides a meaningful upside. An investor not only enjoys the higher level of income available today but also the potential capital appreciation that produces attractive total returns in a falling rate environment.

Returns in Rising and Falling Scenarios Chart web

Why CDs and Money Market Funds may not be the right investment today

Reinvestment Risk

Another important consideration related to the movement in interest rates is the yield at which the proceeds from an investment are reinvested. Interest and principal payments are reinvested at whatever going rate the market dictates when they are received, not at a constant rate. As rates fall, maturing bonds with higher yields are replaced with lower-yielding bonds, reducing income. Conversely, as rates rise, a portfolio’s income rises as low-yielding bonds are replaced with higher-yielding ones. Reinvestment risk is a function of interest rate volatility and the maturity structure of the underlying investment.

With longer-term bonds, in return for taking on the interest rate risk (duration), investors are exposed to less reinvestment risk. With cash or other short-term investments, an investor takes very little interest rate risk but is exposed to extreme reinvestment risk. For example, investor A invests in a money market account yielding 4%, and investor B invests in a five-year bond yielding 4%. After one year, if interest rates decline and the money market account is now yielding 2%, investor A will earn a lower yield. Alternatively, investor B will still earn 4%, as the bond was locked into that rate for five years. In addition, assuming the five-year yield also fell, the investor would enjoy appreciation of the underlying bond. Remember, in a falling rate environment, Total Return = Income + Capital Appreciation.

Of course, rates could also rise from here, and the locked-in 4% bond yield for investor B would become a lower yield than cash. But if the Fed is to be believed and the market’s expectations are correct, the most likely path for rates over the next 12-24 months is lower. While cash or an equivalent investment may provide an attractive yield today, that yield, and therefore the income generated, may evaporate with little to no potential for capital appreciation as rates normalize. A portfolio of intermediate bonds, on the other hand, will maintain most of its income-generating ability while also providing attractive total returns as holdings in the portfolio appreciate.

Both cash and fixed income can play important roles in a portfolio. For some investors, locking in a longer-term cash flow may be important; for others, capital stability may be important. While bonds offer the opportunity for both a fixed income and capital appreciation, cash and money market accounts offer relative safety. The type of investment that is right for you will depend on your investment goals, risk tolerance, and current market conditions.

Why outlook is important

The outlook for interest rates is critical when allocating an investment portfolio, especially when cash and longer-term bonds offer similar yields. Cash can be an important tool when navigating periods of rising interest rates, but only after considering reinvestment risk and the potential opportunity cost of capital appreciation should rates fall. An active fixed income manager can implement views on interest rates, the market, and the economy when constructing a bond portfolio. Decisions such as yield curve positioning, credit quality, and duration exposure can work to reduce risk and take advantage of developments in interest rates.