By John Robinson, May 2022
Where to Put Cash Now
For the past few years, I have been imploring clients to eliminate bond mutual funds and ETFs to protect their “safe” assets in anticipation of interest rates rising. Now that this expectation is coming to fruition, it’s time to get that cash working again. Here are my top 3 recommendations for accumulated cash that is languishing in no/low-interest bank and brokerage accounts:
(1) Series I Savings Bonds from TreasuryDirect.gov (see article link below)
(2) 12-month CDs and 12-month treasuries
(3) FDIC Insured Online Savings/Money Funds
I recommend the 12-month term for CDs and treasuries because it is long enough to lock in rates that are much higher than what we have been getting. At the same time, I do not recommend extending beyond 12 months because rates have been rising quickly. APY’s are currently in the 2-2.2% range. I would not be shocked if 12 month CD rates are back up to 3-4% or higher a year from now, but it is impossible to quantify how much rates may rise over the near term. Interest paid on Treasuries (and savings bonds) is exempt from state income tax. Tax reporting on Treasuries may be more complicated than on CDs.
Online savings account yields are currently in the .60-1.0% range. These rates are lagging a bit relative to CDs and treasuries, but they should continue to rise as well. Compare for yourself at Bankrate.com.
Series I Savings Bonds: What Readers Want to Know (Wall Street Journal)
Why Savers Aren’t Getting Higher Rates with Today’s Red-Hot Inflation (Barron’s)
Where NOT to Put Cash
Now that interest rates have begun rising, some consumers are asking if it is a good time to start investing in bond funds and ETFs again. My response is an emphatic NO! While there are many articles highlighting how badly bond funds have fared in 2022, it is important to remember that interest rates have just begun to rise from historic lows. In my opinion, the worst is yet to come. I would not be surprised to see interest rates rising over much of the next decade. With that thought in mind, here are three surprising investments I recommend avoiding (or selling if you own them):
(1) Target Retirement Date Funds
(2) Balanced Funds
(3) Treasury Inflation-Protected Securities Funds
Read over the employee education material provided at any 401(k) plan meeting and you will surely find brochures showing stock mutual funds as “risky” (color-coded in red/orange) and bond mutual funds as “conservative” (color-coded in cool blue). Indeed the associated historical performance charts likely bear this out by showing the bond funds growing at a fairly modest 5-6% per year with few, if any down years. The problem with this is that bond fund performance is an artifact of steadily declining interest rates over most of the last 40 years. What is often overlooked is that the opposite will occur if interest rates steadily rise over a number of years.
Plan participants who expect their “set-it-and-forget-it” target date retirement funds to gradually shift from risky stocks to conservative bonds as the retirement date approaches may be in for an unpleasant surprise upon discovering that the conservative bond funds may be far less stable than anticipated. To give some perspective, the S&P U.S. Aggregate Bond Index was down 8.61% for the year-to-date through May 20, 2022. Does that feel like conservative to you? We expect that type volatility from stocks. Keep in mind too that interest rates have only just begun to rise from the historic lows of the past few years.
The same logic applies to Balanced mutual funds. These funds which typically maintain a constant stock: bond allocation of 50-60% stocks: 40-50% bonds, are often regarded as all-weather investments. When the stock market is soaring, these funds are touted as allowing ample participation. When stocks are tanking, the bonds are said to serve as volatility buffer. Again, that logic largely held true as interest rates were falling, but that stability may be sorely tested in a rising interest rate environment in which both stocks and bonds get battered.
My general advice to investors in Target Date and Balanced mutual funds is to liquidate the positions and divide the portion that was allocated to stocks into stock index funds and the portion that was allocated bonds into 12-month CDs and treasuries. As rates rise, it may be wise to start laddering the bonds over longer maturities, but, in my opinion, rates have not risen enough to resume that popular interest rate hedging strategy yet.
As for Treasury Inflation Protected Securities (TIPS), one does not need to toss a metaphorical stone very far to hit a finance or econ professor preaching TIPS funds/ETFs as an ideal investment for managing rising inflation. I disagree, the flawed assumption is that because the principal of the TIPs in the portfolio is adjusted each year in accordance with the CPI, the fund will experience price stability as interest rates rise. In reality, that does not necessarily happen because the prices of TIPS on any given day does not necessarily reflect actual inflation, but rather future expectations of interest rates and inflation. To support this point, the S&P TIPS index is down 5.63% for the year-to-date through May 20, 2022.
Although it is beyond the scope of this article, it is worth mentioning that TIPS can also be a tax reporting nightmare in taxable investment accounts. Instead of TIPS funds, I again recommend keeping the maturities short for now with individual CDs and Treasuries and gradually extending the ladder if rates continue to rise over the next few years.
Friend or Foe? The role of duration in target-date funds (John Hancock Inv. Mgmt)
Look Out for Bond Risk in Target Date Funds (Institutional Invsestor)
Move Over 60:40 Portfolio. You’re Out of Date Now (Barron’s)
Protection for Inflation, With Some Leaks (NY Times)
The Benefits and Risks of Treasury Inflation-Protected Securities (The Balance)
John H. Robinson is the owner/founder of Financial Planning Hawaii, Fee-Only Planning Hawaii, and Paraplanning Hawaii. He is also a co-founder of fintech software-maker Nest Egg Guru.