by David Novak
The $64,000 question in the investment world has been the same for several
years: “When are interest rates going to rise?” Despite a strengthening
economy, low unemployment, and the Federal Reserve raising short term interest
rates, intermediate and long term rates have remained stubbornly low.
I find that a lot of clients are hesitant to invest in bonds now and prefer to
keep money in money markets. What they don’t realize is the cost they are incurring by not getting the money invested.
Assume you will earn 0.02 percent annually in money market, and 1.9 percent
per year in a two-year investment grade bond. The table below shows how
much money market rates would need to rise in order to break even with the decision to just buy the two-year bond that pays 1.9 percent.
Holding period Breakeven money market rate
6 months 2.98%
12 months 4.34%
18 months 8.04%
In other words, the rate on money market would have to rise considerably
— to 4.34 percent — over the course of 12 months to make the two-year total return of staying in money market equal to the return of buying the two-year bond and holding it to maturity.
Using the same assumptions, another way of thinking about this would be
to consider how much the two-year bond rate would need to increase in order
to justify waiting to invest the money.
Waiting period Breakeven 2-year bond rate
6 months 2.84%
12 months 3.78%
18 months 4.72%
So if you left the funds in money market for 12 months, you would need the
two-year bond rate to essentially double (from 1.9 to 3.78 percent) in order to
breakeven relative to the decision to just buy the two-year bond that originally
paid 1.9 percent. Furthermore, the longer an investor waits to invest, the more
rates would need to increase to compensate for the lost time.
It is important to remember that this does not have to be an “all or nothing”
decision. Rather, a dollar-cost-averaging approach of systematically investing
ensures that at least some money is put to work now to generate a return.
David Novak, CFP® is a Certified Financial PlannerTM at Novak & Powell
Financial Services in Pinellas County. Please note: he is not an attorney and this
article should not be construed as one offering legal advice. For information
about investment decisions and financial planning, contact him at (727) 451-3440.