In March, performance in risk assets remained mixed, with IG fixed income performing well.
Rising rates have encouraged some investors to shorten duration and enter ultrashort or money market securities. Even though money market strategies have less interest rate risk, we note that their value versus longer strategies via tactical positioning depends on timing the market and correctly predicting the path of rates.
If rates rise more than expected, money market investors benefit because they can reinvest at higher interest rates. However, if a money market allocation is a tactical short duration position, investors must eventually time their re-entry into longer-dated securities. Doing so too late could mean missing the window of rising rates completely, and still holding money market securities as rates fall. In this case:
- The yields on money market funds (MMFs) may fall lower and lower as rates decrease. In an extreme example, during the financial crisis, some MMF investors saw their yields fall from 4 percent in October 2007 to near zero at the end of 2008 (Figure 1).
MMF share prices have remained stable since the effective date of the 2016 money market reforms.1 Still, it is important to recognize that MMF investors may experience changes in yield. MMF yields are never “locked in” and investors may be subject to decreasing income.
- In addition, when the investor decides to re-enter longer-dated bonds, they may have to settle for a lower yield than that available when rates were rising.
Determining the path of rates and correctly timing the markets remains challenging. The U.S. Treasury yield curve fell in August to the flattest level since 2007.2 If the curve inverts, this implies a market consensus that rates will go lower (Figure 2). The curve’s flatness could prompt the Fed to exercise more caution in increasing rates, altering the FOMC’s rate hike trajectory in the future.
A Hypothetical Example
Figure 3 shows a hypothetical four-year period with rates rising 1 percent in year 1 and falling 1 percent in year 2. The graph shows the path of $1,000 investments with various holding periods of 3-month Treasury bills and intermediate Treasury bonds. The graph shows the paths of:
- A 3-Month Treasury bill for the full period (light green solid line)
- An intermediate Treasury bond for the full period (dark green solid line)
- Three different investments in which a 3-Month Treasury bill is moved back into an intermediate Treasury bond at the end of year 1; at the end of year 2; and at the end of year 3 (blue lines).
The graph illustrates that the best outcome goes to the investor who times the market perfectly and comes back into the intermediate market at the end of year one, as rates fall. Only that investor has higher returns over the full period than the investor who simply “sat” in intermediate bonds throughout the timeframe. The investors who stayed in 3-month Treasury bills or who mistimed a tactical re-entry into longer maturities had lower returns.
Given trading costs and the difficulties in timing interest rate markets, we think that investors should perform a careful cost-benefit analysis before moving into money market strategies in response to rising interest rates. At any time, the market could change due to exogenous factors, like geopolitical risks. For long-term investors, the challenges in timing the tactical positioning may outweigh the possible benefits to market return.
Focusing on Income
The main point is that as rates rise, building income in securities longer than MMFs can more than offset the price declines (see: The Trouble with the Curve: Rate Hike Considerations). In a separate account consisting of a well-structured portfolio with diversified maturities, investors can benefit as investments mature and the portfolio reinvests in higher-yielding investments to maintain the duration of the portfolio. Note that the income from a bond investment can matter much more to long-term investment return than changes in market price on the bond (Figure 4).
In addition, looking at separate accounts specifically, one of the main benefits of investing in a separate account versus a mutual fund is that separate account investors own their bonds directly. Separate account investors have the option to hold assets to maturity at a predictable yield (the purchase yield, or book yield),3 and ignore market returns entirely – a choice that could be particularly valuable when rates are rising and market prices could be volatile (see Change is Afoot: Contemplating a Rising Rate Environment).
Mutual funds, in contrast, don’t have the option to ignore market fluctuations and receive a predictable yield on a contractual repayment date. Mutual fund investors must eventually redeem their shares at a constantly fluctuating net asset value (NAV) calculated from the current prices of the fund’s underlying securities. At Breckinridge, even in periods of rising rates, we believe fixed income separate accounts can be a more-stabilizing force for investors.
Key Takeaways for Duration and Rising Rates:
- FOMC policy uncertainty continues to spur volatility in the fixed income market.
- Investors should be cautious in attempts to time changes in rates and should weigh the potential challenges-versus-benefits of moving to MMFs.
- Well-structured strategies with higher duration than MMFs can allow investors to earn additional income as rates rise, helping offset price declines.
- By allocating assets to a separate account invested in investment grade bonds, investors can receive cash flow that is predictable and reliable, and a return that is independent of the market.
- Direct ownership of bonds allows investors to earn a predictable yield without worrying about timing the market correctly.
 In 2016, the SEC established that prime MMFs targeted to institutional investors must move from a stable $1 net asset value (NAV) to a floating NAV, meaning that the funds’ share prices now “float” to reflect the true value of fund assets. Government MMFs and prime MMFs targeted to retail investors remain fixed at $1 NAV.
 Based on the 2s10s U.S. Treasury curve, per Citi data as of September 28, 2018.
 Assumes that bonds do not default.
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