Investors who hold cash and wait for interest rates to rise before buying bonds can make a big mistake. With the Federal Reserve poised to keep interest rates close to zero for at least a year, investors should consider buying short-term corporate bonds now instead of waiting for rates to rise, according to the Schwab Center for Financial Research.
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While liquidity plays an important role in a well-diversified portfolio, it should not be used as a substitute for fixed income, notes Collin Martin, fixed income strategist and director of the Schwab Center for Financial Research. The excess cash can be better utilized by investing in short-term corporate bonds.
“For those who tactically wait for rates to rise before investing in bonds, this strategy comes at a cost: Knowledge.”
Short-term corporate bonds vs cash
As mentioned above, cash has its place in most wallets. Short-term corporate bonds should not replace the cash needed for daily cash needs or short-term expenses, writes Martin. However, investors whose cash is channeled into fixed income would be better off buying short-term corporate bonds now than waiting for interest rate hikes to buy Treasuries.
According to Schwab, not only are interest rates expected to stay close to zero until the end of 2022 or 2023, but short-term corporate bonds also generate better returns than Treasuries. For example, the Bloomberg US Corporate 1-5 Year Bond Index has an average worst return of around 1%, almost double that of the Bloomberg US Treasury 1-5 Year Index (0.51%). Worst return is used to predict the worst possible return on a bond based on when it can be redeemed or canceled by its issuer.
Even if the Federal Reserve raises rates to 1% in a year, investing in short-term bonds would still yield better returns than investing in Treasuries when rates rise.
According to Bloomberg data, an investor who buys $ 10,000 in three-year corporate bonds with a worst-case yield of 1% would have $ 10,300 after three years. Another investor who keeps his $ 10,000 in cash for a year and buys three-month treasury bills when rates hit 1% would end the three-year period with just under, $ 10,200.
But Schwab notes that the federal funds rate, which is determined by the Federal Open Market Committee (FOMC) within the Federal Reserve, is not expected to reach 1% until 2023. “The longer the Fed stays on hold, the longer investors sit. cash may miss out on the higher returns that other investments offer, ”writes Martin.
Turn to fixed rate corporate bonds
When investing in bonds, it is important to distinguish between fixed rate bonds and floating rate bonds.
As the name suggests, 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 pays its holder back against the face value of the bond. For example, a $ 1,000 bond with a 10% coupon rate pays $ 100 per year until maturity.
Variable rate notes, or “floating” notes, have coupons that are variable and fluctuate with federal funds rates.
So why are fixed rate corporate bonds better than free floats? Higher returns. According to Schwab, the average-worst return on the Bloomberg US Corporate 1-5 Year Bond Index is around 1%, more than three times that of the Bloomberg US Floating Rate Notes.
“In the meantime, floating investors earn less income until the Fed starts to raise rates, which can weigh on total returns,” writes Martin. “We think the Fed could start raising rates as early as the end of 2022, but we’re not sure. The longer the Fed stays on hold, the more floating investors miss out on the higher yields available elsewhere. “
With federal funds rates hovering at just 0.25%, investors waiting for interest rates to rise before buying bonds are missing out on more robust short-term yields. According to the Schwab Center for Financial Research, these investors would be better served by buying short-term corporate bonds with fixed interest rates instead of keeping extra cash in their portfolios. Fixed rate corporate bonds not only have higher potential returns than cash, but also outperform floating rate bonds, whose coupon rates fluctuate.
Tips for investing in corporate bonds
If you hope 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, such as the Schwab 1-5 Year Corporate Bond ETF. Read our Guide to Investing in Bond Funds to learn more about this strategy.
Don’t be afraid to ask for help, especially when it comes to your investment portfolio. A financial advisor can help you determine if corporate bonds are right for you and how to add them to your portfolio. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your correspondents free of charge to decide which one is best for you. If you’re ready to find an advisor, start now.
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