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.