The Cost of Waiting for Rates to Rise

January 4, 2012

Kathy A. Jones
Vice President, Fixed Income Strategist, Schwab Center for Financial Research

With interest rates near forty-year lows, many investors are sitting on the sidelines in low-yielding accounts or cash investments, waiting for rates to rise before investing in longer-term bonds.

While current bond yields are quite low, there can be a cost to waiting too long. Sidelined investors are missing out on current income that could be reinvested and compounded. Moreover, by deferring an investment in higher yielding, longer-term securities, investors may also be tempted to take more risk later on to catch up on missed income.

No one knows how long interest rates will stay low. When looking at a longer-term time horizon, we believe investors should take into account the cost of waiting for interest rates to rise when making investing decisions.

Interest rates are low

Low interest rates are making investing difficult for savers. The Federal Reserve has held its short-term funding rate for banks—the "Fed funds rate"—at close to 0.0% since December 2008, and has been pursuing other policies to keep interest rates low. These policies, combined with sluggish economic growth, have contributed to the decline in yields on Treasury securities to the lowest levels in over forty years. Since Treasury securities set the benchmark for most other fixed income securities, rates have moved lower for other types of bonds, such as investment grade corporate and municipal bonds as well as certificates of deposit (CDs), money market funds and other cash investments.

Interest Rates Have Been Falling

Source: Barclays Capital, using the U.S. Treasury, U.S. Corporate, and Municipal Bond Indices to represent yields. Yield-to-worst shown, as of November 30, 2011.

For many investors, unappealing interest rates and concerns about the potential for bond prices to decline if rates do rise have caused them to sit on the sidelines. These are valid concerns since mathematically, yields can't move much lower from current levels. Moreover, there is a place for cash or cash investments in a portfolio. These funds provide liquidity for immediate needs or emergencies, diversification and stability.

However, no one knows when interest rates will rise or how quickly. In fact, in late 2011 the consensus expectation among economists surveyed by Bloomberg looked for interest rates to rise and the Federal Reserve to begin tightening monetary policy. Meanwhile, holding too much of a portfolio in securities with very low yields can mean missing out on current income and the potential for reinvesting and compounding that income.

How the numbers look

Hypothetically, let's look at the difference in projected returns between a low-yielding cash investment, such as a money market fund, with a tax exempt interest rate of 0.17% and compare it to a three-year AA municipal bond yielding 1.5%. Assuming short-term interest rates remain where they are and the investor holds the bonds to maturity, the cash investment would earn $5.11 for every $1,000 invested over three years with semi-annual compounding. That means an investor holding $50,000 in the cash investment would earn roughly $256. During that three-year time frame, the municipal bond would produce $46 in tax exempt income per $1,000 investment over three years or approximately $2,300 for a $50,000 account (for a total ending value of $52,300).

What happens if rates rise?

What if interest rates did begin to rise after the first year? How much would rates have to rise in order to make up the difference? After the first year, interest rates would need to rise to around 2.2% in order to catch up to the return the investor would earn by holding the bond. If rates stayed low for two years, then a jump to above 4% is needed in the third year in order to make up the lost income.

Example: Break even rates for a $50,000 municipal bond investment over a three-year time horizon

Source: Schwab Center for Financial Research. Assumes semi-annual compounding. Hypothetical example for illustrative purposes only.

While increases of this magnitude are not impossible, they are certainly not common. In fact, the steepest rise in short-term rates in recent history was in 1994 - 1995. The Federal Reserve raised short-term interest rates rapidly—doubling the rate from 3% to 6% in a year's time. (They subsequently changed course within six months of the last rate hike and reversed 75 basis points, or .75%, of the increase.)

In late 2011, Federal Reserve Chairman Ben Bernanke indicated that the Fed plans to keep short-term interest rates at 0.0% to 0.25% until "at least" mid-2013. Assuming the Fed raised interest rates beginning in mid-2013, rates would still need to rise to 3% very quickly to break even compared to buying the municipal bond and holding it for three years.

For investors willing to take additional risk by investing in longer-term securities and/or bonds lower on the credit spectrum, the difference in total return can potentially become even greater. For example, a hypothetical investment in a $1,000 face value four-year A-rated corporate bond with a taxable yield of 3.30% would be projected to return roughly $140 in interest payments over the course of four years compared to the money market return of $7 for the money market fund. Translated to a $50,000 portfolio, the corporate bond would provide approximately $7,000 and the cash investment position would produce around $341 in income over the same time period.

Looking at how high short-term rates would need to rise in order to catch up to the bond, we can see from the example below that the longer rates stay low, the steeper the increase in interest rates will need to be to offset the cost of waiting.

Example: Break even rates for a $50,000 corporate bond investment over a four-year time horizon

Source: Schwab Center for Financial Research. Assumes semi-annual compounding. Hypothetical example for illustrative purposes only.

Trying to predict the future direction of interest rates is very difficult, but there is a cost to waiting on the sidelines for rates to increase before investing. We would advise investors to take a longer-term view of their portfolios instead of trying to time interest rate cycles. The cost is foregone income today, and a lost ability to compound returns for long-term objectives. Over time, staying invested for a long-term objective is more important than timing investments, even in a low-rate environment.