Cashing In as Interest Rates Top 4%

Cash is far from trash.

Investors are getting the highest yields in years by keeping their money in super-safe, cashlike instruments. The one-year Treasury bill rate hit 4.08% this week, its loftiest level in more than two decades.

Interest rates across the board have been rising as the Fed lifts its benchmark federal funds rate to combat inflation. But short-term yields have disproportionately benefited as the U.S. central bank front-loads its hikes and pushes them beyond “neutral”—or the spot where rates are neither stimulative nor restrictive.

It’s created a situation where short-term rates are yielding more than longer-term rates. For instance, the widely followed two-year Treasury note was last yielding around 4%, notably more than the 10-year Treasury note, which was yielding 3.58%.

 

 

That means investors in shorter-term bonds are getting paid more, while taking on less interest rate risk. If rates keep rising, bonds with shorter maturities will fall less in price than their longer-term counterparts.

That makes these short-term bonds and the funds that hold them a good way to take advantage of higher interest rates, without necessarily worrying about whether rates will keep going up.

Individual Bonds & Ultra Short-Term Bond ETFs

Investors have many choices when it comes to investing in short-term bonds. An obvious avenue is to invest in the bonds directly. Most major brokerages provide investors with access to bond trading, but because bonds come in all shapes and sizes, the process is more cumbersome—and typically more expensive—than buying stocks or ETFs. 

The advantage of individual bonds is you can hold them to maturity. This eliminates interest rate risk, as an investor will be paid back their full investment at maturity (assuming an issuer doesn’t default). Treasuries held in this way 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, holding Treasuries with maturities of less than a year.

Its price doesn’t move that much. For instance, in March 2020, when interest r ates were at record low levels, the fund traded at $111.05; today, it trades at $109.95. So the fund’s price fell 1% as rates rose from zero to nearly 4%. In the ETF world, that’s as close to stable as you can get.

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Short-Term Bond ETFs 

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

That’s significant, but this is the worst year for bonds in modern history. A fund like VGSH typically won’t move so much, though it’s still important to understand the type of volatility that’s possible with a fund like this.

 

 

This fund is an option for investors who want the added duration of one- to three-year Treasuries over T-bills (Treasuries with maturities of 12 months or less), perhaps because they believe interest rates will eventually decline, pushing up prices for the fund.

Longer-term bond ETFs can also “lock in” interest rates for longer than shorter-term bond ETFs. However, the concept of locking in rates isn’t as straightforward with bond ETFs compared with individual bonds, as bonds are constantly being added and subtracted from bond ETFs. 

There are all sorts of flavors when it comes to these ETFs. SHV and VGSH are among the safest, while other funds might hold riskier bonds like munis, corporates and more to generate higher yields.

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Take a look at ETF.com’s ultra-short-term bond ETF channel and our short-term bond ETF channel for more options.

Money Market Funds 

ETFs aren’t the only fund structure to hold short-term bonds. The money market mutual fund is an even more popular vehicle for generating yield 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 provide investors with something extremely compelling—a stable price. With few exceptions, money market funds maintain a stable $1 net asset value. That’s something that even the aforementioned SHV can’t provide.

For investors who want to see absolutely no fluctuations in the price of their funds, that might be a feature that’s attractive.

Like short-term bond ETFs, money market funds come in different flavors, though they are more restricted regarding the types of securities they can hold. The ones that exclusively hold Treasuries are the safest, like the Vanguard Treasury Money Market Fund (VUSXX).

 

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2

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