Interest rates are clearly on the rise. The Federal Reserve lead by Alan Greenspan has been raising short-term interest rates. Many investors continue to have their bond money parked in money market accounts hoping to wait and invest when interest rates peak. But will it really pay to wait?
There is a good calculator you can access via the web at www.costofwaiting.com that performs a “cost of waiting” calculation. The calculation compares the yield you can lock-in by investing today to what you might earn if you choose to wait. The dilemma is yields might go up but will they go up enough to compensate you for waiting? The inputs needed for the calculator are (1) your investment time horizon in years, (2) current yield based on a security that matures at the end of your investment time horizon, and (3) current money market yield. The calculator then calculates a matrix of annual returns assuming you wait and then invest your money at different time intervals in the remaining time left in your investment horizon. The calculator also calculates breakeven yields required in the future based on waiting a certain period of time. For example, the current 5-year US Treasury Note yields 4.20%. With money market rates at about 2%, the breakeven future yields are as follows:
• If you wait 6 months, you must invest in a bond maturing in 4 ½ years yielding better than 4.45%.
• If you wait 12 months, you must invest in a bond maturing in 4 years yielding better than 4.75%.
• If you wait 24 months, you must invest in a bond maturing in 3 years yielding better than 5.68%.
You first have to ask yourself if you think interest rates will rise this fast. If you are wrong and rates fall, the opportunity to lock-in current levels is lost. Or you could be correct and rates do rise, but not high enough (or soon enough) to offset potential income sacrificed during the waiting period. For example in 2001 interest rates on a 5-year Treasury had dropped to 30-year lows of 3.5%. Most market analysts prognosticated that interest rates had nowhere to go but up. By June of 2003, the 5-year Treasury had dropped to 2.02%, or 40-year lows. Your biggest risk at this point is that rates will not rise far enough, fast enough, to make waiting worthwhile. The calculator noted above allows you to run various scenarios and ‘what-if’ analysis to determine if you should invest now or wait. As I have suggested in previous articles on this subject, if you want to remove the guesswork from your bond investing, you should consider using a bond ladder strategy. With a bond ladder strategy, you divide your bond investments across a series of years. For example, if you had $100,000 to invest, you would buy a $20,000 bond maturing in one year, two years, three years, four years, and five years. If interest rates rise, when your one-year bond matures, you will use the proceeds to buy a five-year bond at the higher interest rate. If interest rates fall, your four remaining bonds are yielding a relatively attractive yield.
My thanks to Hugh Smith, CFA Partner, The Welch Group, LLC for his assistance with this article.