The sharp rise in interest rates over the last 15 months has created a surge in clients looking for short-term investments for their cash.
The Federal Reserve has briefly paused raising rates as part of its campaign to curtail inflation, but the move is expected to be only temporary. Many analysts expect another 0.25% rate hike later this month.
Investment options in this new environment include certificates of deposit, money market funds, short-term Treasurys and longer term vehicles such as government and corporate bonds—lower-risk investments than most equities in the eyes of many. At Blackrock, for instance, clients recently added $48 billion to the firm’s exchange-traded funds, including $35 billion to fixed-income investments.
Clients are noticing. “Many high-net-worth investors are again interested in fixed income as rates are much more attractive, which allows for more interesting options,” said Thomas J. Salvino, CEO and wealth manager at Performance Wealth in Hinsdale, Ill. “Two years ago, the 3-month U.S. Treasury bill was yielding .05 % per year, a year ago the Treasury bill was yielding 1.7% per year and now the U.S. Treasury bill is yielding 5.4% per year. [They’re] rated AAA and backed by … the American government.”
Suddenly, cash is no longer trash. “Many cash alternatives are very attractive today,” said Jeff Mattonelli, financial advisor at Van Leeuwen & Company in Princeton, N.J. “With interest rates having increased significantly over the last year, U.S. Treasury bills and money market mutual funds offer attractive short-term interest rates, which will allow a client to earn interest on these funds while they develop a longer-term strategy. Treasury bills provide the additional benefit of interest that is tax-free from [states and municipalities].”
Following the collapse of regional banks like Silicon Valley Bank and Signature, many affluent Americans moved their cash out of regional banks into Treasurys and treasury funds out of insolvency fears. Still, most fixed-income investments issued by non-government entities are taxed as ordinary income. That's something clientsmay have lost sight of after a decade of near-zero interest rates. And it's one reason many advisors favor tax-exempt municipal bonds and dividend-paying stocks for affluent clients seeking investment income.
A big surge in interest income can also put affluent clients, including retirees, in a higher tax bracket. “If the clients are wealthy and are in mid-to-high income tax brackets, investing… in taxable interest-bearing securities like money market funds or CDs may not be the wisest move,” said Bruce Primeau, a CPA and president of Summit Wealth Advocates in Prior Lake, Minn. “Let’s say they earn $10,000 of interest income on a deposit in a high-yield money market fund. The income tax ramifications may be 37% federal tax, perhaps as high as 10% state tax (like it is here in Minnesota) along with the 3.7% Medicare surtax. That equates to over $5,000 of the $10,000 of interest income being paid in tax. It may make more sense to consider a high-yield municipal bond money market account instead.
(The interest rates for underpayment of taxes has also increased.)
There also could be better uses for surplus cash. “It may make sense to pay down higher-interest rate debt versus putting the bulk of those dollars to work,” Primeau said. “If they are contemplating paying off a 2.5% mortgage, we typically would counsel them to consider what the performance of those funds in their portfolio would look like versus a 2.5% cost of capital.”
“There are many misconceptions about fixed-income investing as being very safe,” Salvino said. “Over time there have been many painful lessons of investors reaching for more yield in companies that, unbeknownst to investors need more cash, and are in bad financial shape, such as telecommunications companies and Wall Street banks that were over-leveraged and didn’t make it out of difficult times [without diluting investors]. The high-yielding bonds and preferred stocks ultimately cause huge losses of principal when high-debt companies don’t survive.
Higher interest rates also highlight risks in the fixed-income sector. At one point lst year, the price 30-year Treasurys were down more than 45% and many banks are sitting on huge losses on long-term bonds. “Credit quality really matters, and high yields are being paid for a reason: high risk,” he said. “Interest rate risk is real and long-duration bonds can and do lose value, which was shown last year. As interest rates increase, corporate debt is becoming more expensive for companies to issue and pay back.
“Keep in mind that inflation is about 4% to 6% now, so after taxes and inflation, fixed-income returns are still not very productive,” Salvino said. “Investing in well-run, profitable companies delivering a service or product needed by the growing global population has proven productive over time and very tax efficient and has handily beaten inflation.”