Taxable Fixed Income

The Cost of Waiting

Currently interest rates continue to hover near 40-year lows. Many investors, dissatisfied with interest rates at all time lows, have elected to leave dollars in cash or money market accounts, expecting interest rates to rise.  Waiting for rates to go up, however, does not always work.  Why? Because the longer an investor stays in cash or cash equivalents, the higher interest rates must rise in order to compensate for waiting.

To illustrate, here are three scenarios comparing two investors with $100,000 each to invest.  The money market investor prefers to stay in cash, believing interest rates will rise and he will be able to lock in at a higher yield later.  The corporate bond investor elects to put his money to work in a five-year A-rated corporate bond.

Scenario #1

Our assumption is that interest rates stay the same over a five-year period.

As you can see, if interest rates stay the same, the corporate bond investor realizes a sizeable return.  Even in the very short run, the money market investor lags behind the corporate bond investor.  In the very first six-month period, the corporate bond investor will earn $2000 (most corporate bonds pay semi-annually), while the money market investor will earn $500. The corporate bond investor is locked in to his coupon and knows exactly what he will earn, while the money market investor can only hope that interest rates rise. In the second six-month period, the corporate bond investor knows he will collect another $2000 for a total of $4000 for the year.  The money market investor, on the other hand, will have to earn $3,500 over the next six months just to catch up with the corporate bond investor.  On the $100,000 investment, short-term interest rates would need to rise to 7% for the money market investor to earn $3,500 over the six month period.

Scenario #2

Let’s suppose interest rates begin at 1% for the money market investor and then increase by 100 basis points for each subsequent year, bringing his yield to 5% for the 5th year.

A rise of 100 basis points in the four subsequent years leaves the money market investor with a significant deficit to the corporate bond investor.

Scenario #3

What is the breakeven point for the money market investor? In order to earn the same annual income as the corporate bond investor, interest rates will need to rise a total of 150 basis points each year, which equates to a total of 600 basis points over a five-year period, resulting in a 7% yield in the 5th year.

As evidenced by the previous scenarios, sometimes the cost of waiting for higher interest rates exceeds the higher returns available in a rising interest rate environment. The increase may not be sufficient to offset the negative difference between today's short-term rates and longer dated securities. Also, keep in mind that in a higher interest rate scenario the corporate bond holder realizes additional income annually, which can be reinvested throughout the life of the bond resulting in an even higher return. 

Scenarios depicted are provided for illustrative purposes only.  If sold prior to maturity, the corporate bond could be worth more or less than the original purchase price dependent upon the then current interest rate environment. Yields reflected in this scenario may or may not be reflective of the current interest rate environment. Information contained in this special report is based upon data obtained from sources deemed reliable; however, City Securities Corporation does not guarantee its completeness or accuracy and is not responsible for any errors or omissions or for unfavorable outcomes resulting from the use of such information. City Securities Corporation does not offer legal or tax advice.  You should seek the advice of a qualified tax attorney or tax advisor prior to making a tax-related insurance or investment decision. Securities and advisory services are provided through City Securities Corporation (Member NASD/SIPC).