Locking in a 5-year US Treasury yield has helped avoid the risk of reinvesting when short-term yields declined.
Even when CD rates were at a peak, history shows, in most cases, investors may have been better off in bond funds.
Two bond strategies that we believe may be options for cash-heavy investors: Investment grade and municipal bonds.
With short-term rates at elevated levels, investing in money markets seems like an easy decision for many income-seeking investors. But history shows us that, over time, “locking in” yields with a longer-term investment may be a better strategy.
For instance, in May 2000 and June 2006, short-term interest rates were as attractive as long-term rates. In both examples, investing in a 5-year US Treasury and locking in the yield avoided the risk of reinvesting at lower rates when short-term yields declined.
Consider these examples: $100,000 invested from May 2000 through May 2005 would have grown to $131,564 in a 5-year US Treasury but only $125,959 when invested in US 6-month Treasuries. That same amount invested from June 2006 through June 2011 would have grown to $125,380 in the 5-year US Treasury but only $117,951 in US 6-month Treasuries.1 (For a chart of this example, see page 9 of Beyond money markets: Maximizing cash.)
With various ways to lock in yields, why might an investor choose a bond fund? Consider this: Some banks are offering one-year CD rates between 4% and 5%, which may look attractive to many investors. But history has shown that even when CD rates are at their peak, in most cases, investors may have been better off investing in bond funds.
The chart below shows the performance of a number of Morningstar fixed income fund groups during times when one-year CD rates were at their peak. At the end of these one-year periods, in most cases, bond funds came out on top versus CDs. Bold numbers in the table below signify times when bond funds outperformed one-year CDs.
Historical 1-year CD returns vs Morningstar peer group returns
| 1984 | 1989 | 1995 | 2000 | 2006 | 2019 | |
|---|---|---|---|---|---|---|
| CDs | 11.24% | 9.21% | 5.69% | 5.52% | 3.79% | 1.00% |
| Ultra-short bond | 11.06% | 9.49% | 7.13% | 7.56% | 3.50% | 1.13% |
| Short-term bond | 19.49% | 8.06% | 10.72% | 9.62% | 4.13% | 2.07% |
| Core bond | 22.95% | 9.26% | 16.55% | 11.90% | 4.16% | 8.72% |
| Core-plus bond | 23.13% | 9.07% | 18.46% | 12.60% | 4.67% | 6.71% |
| Corporate bond | 24.38% | 7.88% | 20.53% | 13.24% | 4.29% | 7.03% |
Sources: Macrobond, Morningstar, Bankrate.com. CD rates are 1-year National Average Rates using month-end data. CD return dates of August 1984, April 1989, February 1995, June 2000, September 2006, and May 2019 represent the period high for one-year CD rates. Morningstar Direct peer universe information was run on 2/8/2023. Morningstar US Fund Ultrashort Bond peer group; Morningstar US Fund Short-Term Bond peer group; US Fund Intermediate Core Bond peer group; US Fund Intermediate Core-Plus Bond peer group; and Morningstar US Fund Corporate Bond peer group. See disclosures for peer group definitions. Past performance does not guarantee future results.
Let’s take a closer look at two types of bond strategies that we believe may be good options for cash-heavy investors: investment grade bonds and municipal bonds. Over rolling 10-year periods, both investment grade corporate bonds and municipal bonds have outperformed T-bills 100% of the time since 2012. (See charts below.)
Source: Macrobond. Historical analysis reviews Bloomberg US Corporate Index (5) and Bloomberg US Treasury Bills Index (6) annualized rolling return data dating back to 2012. The calculation measures how often Corporate Bonds on a rolling 12-month basis have provided a higher return than T-bills measured in that same rolling 12-month period. An investment cannot be made in an index. Past performance is not a guarantee of future results.
With yields at current levels, short and intermediate-term bonds have attractive breakeven characteristics. (See chart below.) Consider this example of a 5-year bond currently yielding 2% and a 10-year bond yielding 3%. In five years, you'd have to be able to buy a 5-year bond yielding 4.01% in order to do as well as you would have if you’d bought the 10-year bond at 3% now. Forward rates are showing us that 5-year bond rates will likely be lower in five years, which makes extending duration more attractive. Currently, the forward rate for the 5-year Treasury five years from now is 3.72%.2
Breakeven analysis total return as of Aug. 18, 2023
| Parallel shift | Current yield-to-worst | Parallel shift | ||||||
|---|---|---|---|---|---|---|---|---|
| Bloomberg indexes | Duration | -150 | -100 | -50 | 50 | 100 | 150 | |
| 1-3-year Corporate Index | 1.79 | 8.50% | 7.61% | 6.71% | 5.82% | 4.92% | 4.02% | 3.13% |
| 3-5-year Corporate Index | 3.50 | 10.93% | 9.18% | 7.43% | 5.68% | 3.93% | 2.17% | 0.42% |
| 5-7-year Corporate Index | 5.21 | 13.45% | 10.84% | 8.24% | 5.64% | 3.03% | 0.43% | -2.17% |
| Aggregate Bond Index | 6.17 | 14.37% | 11.28% | 8.20% | 5.12% | 2.03% | -1.05% | -4.14% |
| US Treasury Index | 5.91 | 13.49% | 10.53% | 7.57% | 4.62% | 1.66% | -1.30% | -4.26% |
Source: Bloomberg L.P, 12/31/22. For illustrative purposes only. Past performance does not guarantee future results.
Bloomberg L.P., USD Overnight Index Swaps (OIS) forward swap 5-year bond in five years, 8/18/2023.
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Disclosures
Index and Peer Group definitions:
CD rates: Bankrate.com US 1 Year CD National Average. These are average rates for new CDs offered by major banks, not an average of already issued CDs.
Morningstar Ultrashort Bond: Ultrashort-bond portfolios invest primarily in investment grade US fixed income issues and have durations typically of less than one year. This category can include corporate or government ultrashort bond portfolios, but it excludes international, convertible, multisector, and high-yield bond portfolios. Because of their focus on bonds with very short durations, these portfolios offer minimal interest-rate sensitivity and, therefore, low risk and total return potential. Morningstar calculates monthly breakpoints using the effective duration of the Morningstar Core Bond Index in determining duration assignment. Ultrashort is defined as 25% of the three-year average effective duration of the Morningstar Core Bond Index.
Morningstar Short Term Bond: Short-term bond portfolios invest primarily in corporate and other investment grade US fixed income issues and have durations of one to 3.5 years (or if duration is unavailable, average effective maturities of one to four years). These portfolios may be attractive to fairly conservative investors because they are less sensitive to interest rates than portfolios with longer durations.
Morningstar Intermediate-Term Core Bond Funds: Intermediate-term core bond portfolios invest primarily in investment grade US fixed income issues, including government, corporate, and securitized debt, and hold less than 5% in below-investment grade exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.
Morningstar Intermediate-Term Core Plus Bond Funds: Intermediate-term core-plus bond portfolios invest primarily in investment grade US fixed-income issues, including government, corporate, and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging markets debt, and non-US currency exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.
Morningstar Corporate Bond Funds: Corporate bond portfolios concentrate on investment grade bonds issued by corporations in US dollars, which tend to have more credit risk than government or agency-backed bonds. These portfolios hold more than 65% of their assets in corporate debt, less than 40% of their assets in non-US debt, less than 35% in below-investment grade debt, and durations that typically range between 75% and 150% of the three-year average of the effective duration of the Morningstar Core Bond Index.
Important information
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Header image: Hero Images Inc / Getty
Past performance is not a guarantee of future results.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
The Bloomberg 1-3 Year US Corporate Index includes US dollar-denominated, investment grade, fixed-rate, taxable securities with maturities between one and three years.
The Bloomberg 3-5 Year US Corporate Index includes US dollar-denominated, investment grade, fixed-rate, taxable securities with maturities between three and five years.
The Bloomberg 5-7 Year US Corporate Index includes US dollar-denominated, investment grade, fixed-rate, taxable securities with maturities between five and seven years.
The Bloomberg US Aggregate Bond Index is an unmanaged index considered representative of the US investment grade, fixed-rate bond market.
The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.
The Bloomberg US Municipal Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury.
The Morningstar Core Bond index measures the performance of fixed rate, investment grade USD-denominated securities with maturities greater than one year.
The information contained herein is proprietary to Morningstar and/or its content providers. It may not be copied or distributed and is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
An investment cannot be made directly in an index.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.
Effective duration calculates the expected price decline of a bond when interest rates rise by 1%.
Yield-to-worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.
Credit spread (bonds) is the difference in yield between bonds of similar maturity but with different credit quality.
Spread represents the difference between the yield on a corporate bond and a similar maturity US Treasury bond.
Parallel shift is when the change in the interest rate on all maturities is the same number of basis points.
Overnight index swaps (OIS) forward swap is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate.
The opinions referenced above are those of the author as of September 8, 2023. These comments should not be construed as recommendations but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties, and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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