INSIGHTS

On May 12, 2011

Why Waiting in Cash Could Cost Your Clients

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In the current historically low and very volatile interest rate environment, investors have shied away from plunging into fixed income investments they have deemed to have an inadequate rate of return or carry too much credit risk. Many investors sit back and wait for just a little more yield; however, they may be unknowingly subjecting themselves to lost income.


To add insult to injury, this waiting period has actually incurred an opportunity cost upon the investor. Let’s compare and contrast two investors: a bond investor who accepts market conditions and willingly invests in a 5-year A-rated corporate bond yielding 3.35% at par and a cash investor who is currently parking the money in a money market fund paying 0.40%, and adamantly waits until bonds are paying 3.75% in year 2. The example assumes an investment of $100,000.

Interest Income Example #1

	Bond Investor	Cash Investor
Year 1	$3,350	$400
Year 2	$3,350	$3,750
Year 3	$3,350	$3,750
Year 4	$3,350	$3,750
Year 5	$3,350	$3,750
	$16,750	$15,400
	Difference of $1,350

The table illustrates that even if the investor only had to wait one year to purchase a

4-year bond paying 3.75%, their final cash flow would actually be $1,350 less than the investor who didn’t wait. Additionally, this example does not include the extra compounding of interest that the first bond investor would have realized from the greater cash flow in the first year. In reality, this scenario is quite generous to the investor who waited and also presumes that the investor is accurate in predicting future rates.


What if it took longer for interest rates to rise as shown in the next illustration, which assumes rates didn’t increase until year 3? Where would rates have to be to equate the two investment decisions?


The table below shows that the investor who waited two years would need to be able to invest in a 3-year A-rated corporate bond yielding 5.32% to receive approximately the same total cash flow that the immediate bond investor collects at the end of five years. That’s quite an increase in yield!

Interest Income Example #2

	Bond Investor	Cash Investor
Year 1	$3,350	$400
Year 2	$3,350	$400
Year 3	$3,350	$5,316
Year 4	$3,350	$5,316
Year 5	$3,350	$5,316
	$16,750	$16,750
	Difference Nominal

These illustrations show opportunity cost. Investors should understand that even if rates could be predicted accurately, the interest income that is lost can only be made up if rates were to rise high enough to compensate for not investing early on. In reality, market timing is very difficult, if not impossible to do for both equities and bonds. The difference is that fixed income investing allows the investor to immediately lock in a yield and benefit from the stream of cash flow. Understanding this might make the difference in taking what the market offers or playing catch-up.

Tables are for illustrative purposes only and should not be relied upon to make any investment decision. Investors should consult their financial professional before investing.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.

An investment in Corporate Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the bond market, possible downgrades and defaults of interest and/or principal. Interest rate risk is the risk that the value of a bond will fall if interest rates increase. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bonds with a longer period before maturity are often more sensitive to interest rate changes. Additionally, the financial condition of the issuer may worsen or its credit ratings may drop. A bond issuer might also prepay or “call” a bond before its stated maturity.