Time to consider cash equivalents as a viable investment again…
After years of near zero and sub 1% yields for cash equivalents, floating rate debt, & short/ultra short term bonds (I will call them USBs), they now offer competitive yields versus bonds (US 10 Year Treasury 2.95%) and stocks (S&P 500 1.82%), as you can see in the chart below.
Source: Bloomberg. Commercial paper is the average yield in the 30-Day A2/P2 Non-Financial Commercial Paper Interest Rate Index. IG FRN is the average coupon in the Bloomberg Barclays Investment Grade Floating Rate Note Index..
In addition to providing a competitive yield, USBs have relatively lower duration risk versus a US 10 Year Treasury, since they mature quickly (in less than a year), allowing you to roll up to higher rates in a rising rate environment. A buyer of the US 10 Year Treasury at 2.95% is locked in for 10 years and as rates rise, the price will drop more than USBs. A 30 year bond has more duration risk relative to a 10 year bond since the holder in locked in for 30 years before they can reinvest.
While USBs will not give you the upside that stocks will in the long term, they avoid the volatility that can occur for stocks in a rapidly rising rate environment. This is because stocks have the highest duration risk since stocks don’t mature, while a 10 year bond does mature in 10 years. Many will recall the rapidly rising interest rate environment from 1975 to 1982, which caused havoc for the stock market. Back then, investors allocated more/most of their investments to short term CDs and money market funds, earning rates in the high teens! While I don’t see rates moving that high again, there is a risk that rates can move rapidly higher off from the current low levels and USBs will benefit should this happen.
At the fork in the road, go left and right…
At this investment fork in the road in front of us, USBs are a viable investment again as they offer competitive yields and a buffer to volatility. The right allocation percentage to USBs will depend on the current income/total return needs and risk tolerance of each individual. While we have factored in these two variables to change your allocation as we see fit, we welcome your input as we recognize that the risk tolerance of an investor changes over time, particularly during periods of extreme market volatility like what we experienced in early February.