The Cost of Waiting
Many investors expect interest rates to rise in the future, and with interest rates near all-time lows, are reluctant to
invest in longer-term securities. It is important to understand that waiting for higher rates may have a cost: an investor
who chooses to keep money in cash and waits until interest rates increase will forego the higher yields currently
available from bonds with a stated maturity. Even in the current interest rate environment, choosing to stay in cash as
opposed to extending maturity could surrender a significant amount of income and total return over the life of the
investment. This piece will illustrate a few scenarios to shed light on the topic and help clarify the true cost of waiting.
In the following circumstances we assume an investor has $100,000 to invest in a money market instrument or a
corporate ‘A’ bond for a 2-year period. To help illustrate the effects of waiting during those 2 years, we examine what
the breakeven income will be for money market rates if they were to increase after 6, 12, and 18 months.
Example: Two-Year Maturities versus Staying in Money Market
Let’s first take a look at what would happen if an investor chose to wait 2 years for rates to increase, only to realize that
rates did not move at all during this timeframe. We assume that money markets return 0.10% per year, while a 2-year
Corporate A-rated bond yields 0.70% (for the corporate bond yield we are using the indicative rate provided by
Bloomberg’s Corporate ‘A’ yield curve). It should be noted that money market rates typically follow the direction of the
Federal Funds Rate and often do so at a slight lag. For the purposes of this discussion, it is assumed that the investor
does not need access to the money until the end of a two year time period.
The following table shows three scenarios in which short term interest rates could rise in the future: at 6, 12, and 18
months. In each scenario, we assume that the initial money market rate of approximately 0.10% remains constant for 6,
12, or 18 months, respectively, before beginning to rise steadily until the end of the two year period. The resulting
break even rates reflect the level that the final money market rate would have to reach in order for the money market
investment to match that of investing instead in a 2 year ‘A’ rated corporate bond held to maturity.
For example, the money market rate will have to rise to a final yield of 1.62%, starting at a rate of 0.10%, in month 6 for
the return on money markets to equal that of a current corporate bond over the next 2 years. Even if rates began
increasing in 6-months, it would take a money market rate increase up to 1.62% to merely match the rate of a current 2year corporate bond.
To What Rate Do Money Markets Need to Rise In Order To Match the Income from a Current 2-year Bond?
6-mo
12-mo
18-mo
Initial Rate
Breakeven Rate
(to 2-year 'A' Bond)
0.10%
0.10%
0.10%
1.62%
2.32%
4.21%
(Source: Bloomberg LP, Raymond James)
A money market rate of 0.10% will have
to rise substantially for its return to
match that of a 2-year ‘A’ corporate
bond held to maturity.
Yields Need to Rise Substantially to Compensate for Lost Time
Current Yield Available for 2 Year Corporate 'A'
Bond: 0.70%
IF You Wait
Months
3
6
9
12
15
18
Money
Market
Return
0.025%
0.050%
0.075%
0.100%
0.125%
0.150%
2-year Bond Original
Return
Bond Rate
0.175%
0.350%
0.525%
0.700%
0.875%
1.050%
0.700%
0.700%
0.700%
0.700%
0.700%
0.700%
Breakeven
Bond Rate
0.850%
1.000%
1.150%
1.300%
1.450%
1.600%
Money Market Rate is 0.10%
(Source: Bloomberg LP, Raymond James)
Another way of thinking about this concept is to examine what would need to happen to the rate of corporate bonds
rather than the money market rate. In the scenario above we highlight several holding periods and indicate what rate a
corporate ‘A’ bond would need to rise to for a cash investor to breakeven. For example, an investor who spends 1 year
in cash at 0.10% and the following year in a corporate bond yielding 1.30%, averaging 0.70% over the two years, would
breakeven to the original corporate rate of 0.70% per year. In other words, an investor who stays in cash for 1 year
earning 0.10% would need the 2-year corporate rate to increase from 0.70% to 1.30%, nearly doubling, to breakeven on
a 2-year investment horizon. Looking at the table above, it is apparent that the longer an investor waits to invest at
current rates the higher the rates need to go to compensate for lost time.
Implications for Today’s Steep Yield Curve
As evidenced by the 2-year scenario above, the cost of waiting for interest rates to rise is considerable. The increase in
interest rates in the future may not be sufficient to offset the negative impact on income during the holding period.
Currently, the steepest area of the yield curve (between 3 and 10 years) is where an investor receives the greatest
amount of extra yield for extending maturity. This is also the area of the yield curve in which the cost of waiting is
highest. We continue to stress cash flows and diversification by staggering investments among different bond maturities
to create periodic reinvestment opportunities and potentially optimize returns over time. Should rates increase, a
portion of the portfolio could be reinvested at the higher prevailing rates, as a portion of the portfolio will always be
near maturity.
It is important to note that this strategy is dependent upon holding the securities until maturity. If funds are needed
prior to maturity, proceeds may be less than the original investment if interest rates have risen since the purchase.
Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed
may differ from opinions expressed by other departments of RJA and are subject to change without notice. The data and information contained herein was
obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions
expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or
derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the
report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in
bonds with their Raymond James Financial Advisor. Past performance is no assurance of future results.
Diversification does not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal. This
communication is intended to improve the efficiency with which Financial Advisors obtain information relevant to their client's taxable fixed income holdings.
This information should not be construed as a directive from the RJ&A Taxable Fixed Income Department to buy or sell the securities noted above. Prior to
transacting in any security, please discuss the suitability, potential returns, and associated risks of the transactions(s) with your client. For additional
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The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is
not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Trading ideas
expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual
investors. Investors are urged to obtain and review the relevant documents in their entirety. RJA is providing this communication on the condition that it will
not form the primary basis for any investment decision you may make. Furthermore, because these are only trade ideas, investors should assume that RJA
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