Investors holding cash and waiting for interest rates to rise before buying bonds may be making a significant mistake. With the Federal Reserve poised to keep interest rates near zero for at least another year, investors should consider purchasing short-term corporate bonds now instead of waiting for rates to rise, according to the Schwab Center for Financial Research.
While cash plays an important role in a well-diversified portfolio, it shouldn’t serve as a proxy for fixed-income securities, notes Collin Martin, a fixed-income strategist and director of the Schwab Center for Financial Research. The surplus cash can be put to better use by investing in short-term corporate bonds.
“For those tactically waiting for rates to rise before investing in bonds, there is a cost to that strategy: the opportunity cost of compounding the higher yields that are available today in other high-quality investments,” Martin writes in Schwab’s most recent “Bond Insights.”
Short-Term Corporate Bonds vs. Cash
As mentioned above, cash has a place in most portfolios. Short-term corporate bonds should not replace cash needed for daily liquidity needs or near-term expenses, Martin writes. However, investors with cash earmarked for fixed-income securities are better off buying short-term corporate bonds now than waiting for interest rate hikes to buy Treasury bills.
Not only are interest rates expected to remain near zero until late-2022 or 2023, according to Schwab, but short-term corporate bonds also generate better yields than Treasury bills. For example, the Bloomberg U.S. Corporate 1-5 Year Bond Index has an average yield-to-worst of roughly 1%, nearly double that of the Bloomberg U.S. Treasury 1-5 Year Index (0.51%). Yield-to-worst is used to predict the worst possible yield of a bond based on the earliest it can be called or retired by its issuer.
Even if the Federal Reserve raises rates to 1% in one year, investing in short-term bonds would still net better returns than investing in Treasury bills when rates rise.
According to Bloomberg data, an investor who buys $10,000 worth of three-year corporate bonds with a yield-to-worst of 1% would have $10,300 after three years. Another investor who keeps their $10,000 in cash for one year and buy three-month Treasury bills when rates go to 1% would end the three-year period with slightly less, $10,200.
But Schwab notes that the federal funds rate, which is determined by the Federal Open Market Committee (FOMC) within the Federal Reserve System, isn’t expected to hit 1% until 2023. “The longer the Fed remains on hold, the longer investors sitting in cash may miss out on the higher yields that other investments offer,” Martin writes.
Look to Fixed-Rate Corporate Bonds
When investing in bonds, it’s important to distinguish between fixed-rate bonds and floating rate notes.
As their name indicates, fixed rate bonds have coupons that remain constant throughout the life of the bond. A coupon rate is simply the annual rate at which the bond repays its holder relative to the bond’s par value. For example, a $1,000 bond with a coupon rate of 10% pays out $100 per year until reaching maturity.
Floating rate notes, or “floaters,” have coupons that are variable and fluctuate based on the federal funds rates.
So why are fixed-rate corporate bonds preferable to floaters? Higher yields. According to Schwab, the average yield-to-worst of the Bloomberg U.S. Corporate 1-5 Year Bond Index is approximately 1%, more than three times that of the Bloomberg U.S. Floating Rate Notes Index.
“In the meantime, floater investors are earning less income until the Fed starts to hike rates, which can weigh on total returns,” Martin writes. “We believe the Fed could begin hiking rates as early as late 2022, but we don’t know for sure. The longer the Fed remains on hold, the longer floater investors are missing out on higher yields available elsewhere.”
With federal fund rates hovering at just 0.25%, investors who are waiting for interest rates to rise before buying bonds are missing out on more robust short-term returns. These investors would be better served by purchasing short-term corporate bonds with fixed coupon rates instead of keeping extra cash in their portfolios, according to the Schwab Center for Financial Research. Fixed-rate corporate bonds not only present higher potential returns than cash, but also outperform floating-rate notes, whose coupon rates fluctuate.
Tips for Investing in Corporate Bonds
If you’re hoping to diversify your portfolio with more fixed-income securities like corporate bonds, you don’t have to buy bonds individually. You can also invest in mutual funds and exchange-traded funds (ETFs) whose holdings are exclusively corporate bonds, like the Schwab 1-5 Year Corporate Bond ETF. Read our Guide to Investing in Bond Funds for a deeper dive into this strategy.
Don’t be afraid to seek out help, especially when it comes to your investment portfolio. A financial advisor can help you determine whether corporate bonds are right for you and how to integrate them into your portfolio. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.