Cashing in as Interest Rates Top 4%

Cashing in as Interest Rates Top 4%

Cash is far from waste.

Investors get the highest returns in years by holding their money in super safe, cash instruments. The one-year Treasury yield reached 4.08% this week, the highest level in more than two decades.

Interest rates have risen across the board as the Fed raises its benchmark federal funds rate to fight inflation. But short-term yields have benefited disproportionately as the US central bank pushes through its rate hikes in advance and pushes them beyond “neutral” – the point where interest rates are neither stimulative nor restrictive.

It has created a situation where short-term rates yield more than long-term rates. For example, the widely followed two-year treasury last returned about 4%, notably more than the 10-year treasury, which returned 3.58%.

This means that investors in short-term bonds get paid more, while running less interest rate risk. If interest rates continue to rise, shorter-dated bonds will fall in price less than their longer-dated counterparts.

That makes these short-term bonds and the funds they hold a great way to take advantage of higher interest rates, without necessarily worrying about whether rates will continue to rise.

Individual bonds and ultra-short bond ETFs

Investors have many choices when it comes to investing in short-term bonds. An obvious option is to invest directly in the bonds. Most major brokers offer investors access to bond trading, but because bondse of all shapes and sizes, the process is more cumbersome — and usually more expensive — than buying stocks or ETFs.

The advantage of individual bonds is that you can hold them until maturity. This eliminates interest rate risk, as an investor will be repaid their entire investment at maturity (assuming an issuer does not default). Treasuries held in this manner are risk-free.

Investors who don’t want to deal with individual bonds can use ETFs to buy bonds in a simple and straightforward way. The iShares Short Treasury Bond ETF (SHV) is a T-bill ETF, which holds government bonds with maturities of less than one year.

The price doesn’t move that much. For example, in March 2020, when interest rates were at record lows, the fund traded at $111.05; today it trades at $109.95. So the price of the fund fell 1% while interest rates rose from zero to almost 4%. In the ETF world, that’s as close to stable as you can get.

Short-Term Bond ETFs

For investors willing to take a little more interest rate risk, the Vanguard Short Term Treasury Index ETF (VGSH) is an option. It holds Treasuries with maturities ranging from one to three years. If you look at the same period as above (March 2020 to today), you will see that prices for this ETF have fallen 7% from high to low.

That’s important, but this is the worst year for bonds in modern history. A fund like VGSH will typically not move that much, although it is still important to understand the kind of volatility that is possible with a fund like this.

This fund is an option for investors who want the additional maturity of one to three years of Treasuries over T-bills (Treasuries with a maturity of 12 months or less), perhaps because they believe that yields will eventually fall, pushing prices for the fund.

Longer-dated bond ETFs can also interrest rates for ETFs for bonds with a longer maturity than those with a shorter maturity. However, the concept of fixing interest rates is not so straightforward with bond ETFs compared to individual bonds, as bonds are constantly added and subtracted from bond ETFs.

There are all kinds of flavors when it comes to these ETFs. SHV and VGSH are among the safest, while other funds may hold riskier bonds such as munis, corporate bonds and more to generate higher yields.

Check out ETF.com’s Ultra Short Bond ETF Channel and our Short Term Bond ETF Channel for more options.

Money Market Funds

ETFs aren’t the only fund structure holding short-term bonds. The money market mutual fund is an even more popular means of generating returns on cash.

Money market funds are strictly regulated and must follow Rule 2a-7 of the Investment Company Act of 1940. They have restrictions on the types of securities they can hold and how much liquidity the funds have on hand.

Those restrictions make money markets extremely safe and allow them to offer investors something extraordinary: a stable price. With a few exceptions, money market funds maintain a stable net asset value of $1. That’s something that even the aforementioned SHV can’t offer.

For investors who want absolutely no fluctuations in the price of their funds, this can be an attractive feature.

Like short-term bond ETFs, money market funds come in a variety of flavors, although they are more limited in terms of the types of securities they can hold. Those that exclusively hold Treasuries are the safest, such as the Vanguard Treasury Money Market Fund (VUSXX).

Email Sumit Roy at: sroy@etf.com or follow him on Twitter @sumitroy2

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