As the Federal Reserve embarks on a path of interest rate cuts, the implications for investors, particularly those reliant on money market funds, are becoming increasingly evident. This shift has raised critical questions about where to allocate cash that investors may not need in the immediate future while still seeking to generate reasonable income.
The Declining Yield Landscape
In recent developments, money market fund yields have already begun to retract following the Fed’s decision to cut rates. The substantial assets in these funds, which amounted to approximately $6.47 trillion as of mid-October, are no longer providing the attractive returns they once did. For instance, the Crane 100 Money Fund Index displayed an annualized seven-day yield of just 4.69% as of October 14, a notable drop from peaks over 5.1% experienced in late July. The trend indicates that as the Fed continues reducing interest rates, yields across various cash-equivalent holdings are likely to decrease further.
With current yields dwindling, investors sitting on idle cash that they do not intend to use for the next 12 to 18 months might need to seek alternative investment options. “There’s approximately $6 trillion sitting in cash, and individuals are motivated to find a productive home for these funds,” notes Brett Sheely, head of ETF specialists at AllianceBernstein.
Considering Duration: A Strategic Approach
An essential concept influencing bond investment strategies is duration, which reflects a bond’s sensitivity to interest rate fluctuations. Bonds with longer maturities typically exhibit increased duration, making them more susceptible to price changes as interest rates move. In light of the current rate-cutting cycle, financial advisors are increasingly recommending that investors include bonds with intermediate durations—around six years—into their portfolios. This strategy enables investors to capture potential price appreciation as bond prices rise when yields fall.
Conversely, for cash that may be required sooner—within a year or so—short-duration bonds can offer a suitable alternative. These financial instruments generally provide greater stability in price while delivering slightly better yields than cash accounts might offer, even amidst decreasing interest rates. Strategically, this is where ultra-short and short-term bond funds become essential components of a diversified portfolio.
Matthew Bartolini, managing director at State Street Global Advisors, articulates this need succinctly, asking how investors can maintain relatively high yields without jeopardizing principal. In this context, ultra-short bond funds featuring durations of one to three years offer a balanced approach for cash management.
For those interested in specific fund options to consider, various choices stand out. Vanguard’s Ultra-Short Bond ETF (VUSB) appears attractive, with an impressively low expense ratio of 0.1% and a 30-day SEC yield of 3.54%. Additionally, AllianceBernstein’s Ultra Short Income (YEAR) boasts a slightly higher yield at 4.81%, albeit with a 0.25% expense ratio.
Furthermore, tax-conscious investors may wish to explore short-duration municipal bond funds. These options not only provide income but do so in a tax-efficient manner, as the interest earned is typically exempt from federal income tax. By contrast, corporate bond earnings are subject to higher tax rates, potentially diminishing their attractiveness for some investors.
Despite these appealing yields, it is important for investors to maintain a keen awareness of credit risk associated with the bonds held within their selected funds. Instances from the financial crisis of 2008 serve as cautionary tales, when ultra-short bond funds suffered significant losses due to risky underlying assets.
For those who prefer to minimize risk altogether, traditional options such as certificates of deposit (CDs) and high-yield savings accounts remain available. Although some banks, such as Bread Financial, recently reduced their CD rates from 5.25% to 4.3%, these accounts still present relatively low-risk opportunities for earning interest. According to BTIG analyst Vincent Caintic, as online banks adjust their rates to remain competitive, expectations for further reductions in savings account APYs are apparent.
Another secure option includes Treasury bills (T-bills), which are backed by the full faith of the U.S. government. T-bills offer additional allure by being exempt from state and local taxes, making them particularly advantageous for high-income earners in states with elevated tax rates.
As the Federal Reserve continues its cycle of rate cuts, investors must proactively consider their cash management strategies. Whether through bond funds with varying durations, tax-efficient municipal bonds, or traditional savings vehicles, understanding the prevailing market landscape is crucial for making informed investment decisions that align with individual financial goals.