The Federal Reserve hiked the Fed funds rate 3 times in 2017 and projected 3 more hikes for 2018. Should you consider investing in fixed income?
We’re familiar with the saying “nothing ventured, nothing gained.” At least nothing is lost, either, right? But in some cases, the “nothing ventured” choice may come at a cost—opportunity cost, or “the cost of waiting.”
When it comes to interest-bearing securities such as certificates of deposit (CDs), bonds, and other fixed income securities, keeping cash on the sidelines may mean time is passing but some assets aren’t earning interest.
The Federal Reserve raised the Fed funds rate three times in 2017, each time by a quarter-point, and has projected three more such hikes in 2018. Some investors might look at this tightening cycle as a reason to wait. After all, investors a higher rate, right?
Because fixed income investments pay interest, many investors look for securities that offer the highest yields (the income return of an investment), meaning that some investors will try to time the market. For example, they might wait for the Federal Reserve to hike interest rates before jumping in to invest. But such hesitation comes at a cost: if speculative efforts to time the market don’t work out, meaning that the expected yield doesn’t appear, then investors may have missed out on income opportunities. (If you’re unfamiliar with the basics of fixed income investing, please refer to this recent primer).
For example, suppose you have the opportunity to invest $100,000 into a fixed income security yielding 3% annually, with a maturity date 10 years from the time of purchase. And for simplicity’s sake, we’ll assume no compounding of interest.
Here are a few hypothetical scenarios. Each assumes you’ll hold your investment through to maturity (10 years). Remember that selling your investment before maturity may result in a loss of principal, as explained in this beginner’s guide to fixed income investing.
Scenario 1: You decide to invest now.Say you invest $100,000 in a fixed income security yielding 3%, as described above. At the end of 10 years, you will have generated a total income of ($100,000 x 10 years x 0.03) = $30,000.
Scenario 2: You wait one year and invest in a fixed income security yielding 3.25%.Interest rates have risen. After a year of sitting on the cash, you find an opportunity to invest $100,000 into a security yielding a higher rate of 3.25%. At the end of your original 10-year period, you would have earned 9 years’ worth of interest, having skipped the first year. This will give you an income total of $29,250. That’s $750 less than what you would have earned in the previous scenario—not bad, but still short. Of course, this is just one potential scenario in which yields have moved in your favor.
Want to know what increased interest rate would allow you to break even? Solve for X. If:
If ($100,000 x 9 years) x X = $30,000, then X = 0.0333
If you sat on the sidelines for a year, and then invested at 3.33% or higher, your income would exceed the cost of waiting.
Scenario 3: You wait one year and yields fall.Suppose you decide to hold off a year in anticipation of higher interest rates. But instead, the economy stalls, and interest rates fall. Now you’re facing lower yields. Instead of that 3% yield of yesteryear, a similar low-risk security may yield, say, 2.75%. At the end of your original 10-year time frame, after having waited a year, your income will be only $24,750—$5,250 less than the original investment opportunity.
You might be tempted to sit on the sidelines in anticipation of higher yields. But just remember that attempts to time the market are fraught with uncertainty.
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