When 0% is OK

Not surprisingly, I've had a few conversations with clients about the lousy rates being paid on savings accounts and money-market balances and, to a lesser extent, short-term bonds. For money-market funds especially, the interest rate might as well be zero. Let's take a look at why 0% can be OK.

First, taking a step back...what is the point of holding cash and short-term bonds at all? It's twofold: cash and short-term bonds are a source of funds that you know can be tapped at any time, irrespective of what's going on with financial markets. And they're a way of stabilizing the value of your overall investment portfolio, which can be desirable for many reasons - not least of which is reducing the anxiety you'll feel when your stock investments have one of their inevitable drops. The ability to stay the course with a riskier investment is definitely a factor in the likelihood of that risk paying off.

Ideally that stable money isn't idle, sitting under your mattress. The goal is earning at least enough to keep pace with inflation. That may not always be possible though, and it's important to keep in mind that the main goal for this part of an investment portfolio isn't earning money, it's preserving it.

With that in mind let's take a look at the bond quotes I saw in my bond-trading system one random day in December 2011:

less than zeroThe first line, which is the quote for the 3-month Treasury Bill, is saying that you will pay more than $100 to receive $100 back from the US Treasury in three months. Or put another way, the 3-month T-bill had a negative yield - that's the minus sign before the 0.003 in the yield column. That's right - a buyer at that price was paying Uncle Sam to store money for three months!

This actually isn't so strange if you consider who some of the buyers of Treasury Bills are. Imagine you are the CFO at a big corporation sitting on billions of dollars of excess cash that you might use for who-knows-what at any time in the near future. You need to do something with that money, and you can't put it at risk. Individuals can use banks for this sort of thing, but it's not quite the same when you're storing billions instead of mere thousands of dollars. Central banks of countries that accumulate dollars from trade are in a similar situation.

The interest paid on a Treasury Bill represents the "risk-free rate" because few people believe that the US Treasury won't make good on the debt. If you want, or are required to buy, a risk-free investment, a T-bill fits the bill. The manager of a government-security money-market fund is an example of someone required to put at least some of their money into T-bills. And thinking about it from that manager's perspective, the low money-market rates make sense; the funds simply pass on the interest earned by the securities they buy, after taking away expenses. If there's nothing coming in, there won't be anything going out.

In practice most money-market funds don't invest just in T-bills, they'll own similar short-term securities issued by corporations and other entities. Those rates are a bit higher, but still barely register. The same can be said of short-term bonds, which would normally yield a good bit more than a money-market fund. It's all a symptom of the central issue, which is that the economy is pulling out of a recession and the lending rate set by the Federal Reserve and market forces is close to zero. Everything of higher risk, whether because of the issuer or the term of the loan, keys off of that. The current cost of money, at least for the short-term, is extremely low, and if you're a lender - as you are, of sorts, when you deposit cash at a bank or purchase shares of a money-market fund - you aren't earning much for that activity.

But that's OK. Look a litle further down the list of quotes above and you'll see that the longer-term bonds were paying spit too.  The Treasury quotes above show tiny yields for the 1-, 2-, and 3- year issues - less than half a percent annually. Those low rates are mirrored in the rates paid on corporate debt. As an extreme example of that, IBM was able to issue three-year debt recently at a rate of just 0.75%.

What about going to longer terms than that? Normally longer-term bonds, at least intermediate-term bonds, have higher yields to compensate you for the inconvenience of giving up your money for longer, and the risk that inflation and available interest rates will eventually turn against you during that longer period. But this time, there's not much help there either. You can see above that a 10-year Treasury Bond was quoted at a yield of just 1.826% at the time (its coupon was 2% so the price was above par). A purchaser of this bond would be handing over $1,015.70, and receiving $20 per year for ten years...after which the Treasury hands back the $1,000 principal. The  "nominal yield" is low to begin with. But we use cash to buy things so inflation matters. And with even modest inflation of 2% per year, that represents a loss, in "real" terms - meaning when you look at the purchasing power of the money over time. Visually it looks like this, expressing the end-point in 2012 dollars:

 

Isn't that better than nothing? Maybe not...unless you have a very pessimistic view of the next 10 years. The reason is that when bonds pay very low interest rates, they come with the risk of large drops in value should interest rates rise, as they are likely to as the recession unwinds. Below is a chart showing the change in price of a 2%-coupon Treasury bond that would result if interest rates changed to the level shown, one year after initial purchase. The 10-year bond - which at that point would be a nine-year bond - would drop a lot more in price than a 5- or 2- year bond bought today. The reason is that a 10-year, 2%-coupon bond locks you into those 2% coupon payments for another 9 years; the 2-year would just have a year of suffering left.

 

All of which is a roundabout way of saying that 0% can be OK, when the alternative is just too low to bother with, when factoring in the risks. You can go a long time earning 0% and still come out ahead, when the alternative is buying a bond that might lose 15% of its value if rates returned to the levels they were at just couple years ago. Remember, the point of this part of the portfolio is stability -- and that hardly qualifies. Sure, a shift in Treasury bond rates to 7% is unlikely in a year, but relatively fast changes of 2-3% are not all that uncommon, and those can produce noticeable price drops in bonds paying very low coupon rates. Look forward a few more years, and it seems likely that rates would have drifted upward from the their recent position at or near all-time lows. It's possible rates will stay that low for a very long time, but how likely is it? Ten years is a long time.

Some argue that those price drops from rate changes aren't really losses for those who continue to hold the bond until maturity. That argument may hold water for the sort of large entities that buy 2%-coupon bonds out of necessity, particularly those that are matching the bond maturities and coupons to known future cash needs - an insurance company making good on payments of a fixed annuity is an example (bond rates put a limit on the rates paid on annuities of that type). The reality for an individual investor though is that holding that bond has a very real opportunity cost< - if only you'd waited, you could have bought into the higher yield.

And that's what 0% cash represents, in part: waiting. At some point, it's likely that interest rates will move back above the all-time lows that we've seen recently. It's possible that they won't, and buyers of those <0.5%-yield bonds will come out ahead, but my belief is that the cost of being wrong is too high. Earning 0% stinks, sure, but anything earning more comes with its own set of risks. That concept has always applied, whether the short-term rates were 1%, 3% or 6%; it's just that much more visible now.

Are we done with the charts yet? Just two more, for perspective...from the Federal Reserve in St. Louis, a historical look at Treasury bill and 10-year Treasury bond rates, show just how rare the current rates are.