Strategies for managing cash and near cash have become increasingly important as the Fed has raised short term rates and indicated its intention to raise them further. Rising short term rates have important implications for an overall portfolio, but they have also come to suggest a close look at the choices for cash itself. Some of the strategies worth considering are more generally applied to a bond portfolio.
Should you look for the sweet spot at the short end of the yield curve? Should you try to ladder your short term cash by buying equal amounts of six month bills over a period of six months and then reinvesting as the nearest month reaches maturity? My son informed me that he was using this approach, and I looked at this pretty darn good option in this earlier article.
The current article considers an approach that bears resemblance to a common bond strategy known as a "barbell." A barbell strategy combines a concentration at the short end of the yield curve and another concentration at the long end, excluding the middle. T-Bills or short duration Notes combined with the 10-year Bond (sometimes even longer) is an occasional choice in bond portfolios. It reflects a desire to lock in a particular rate with long duration while maintaining flexibility at the short durations in order to take action if conditions change. The rationale behind this barbell approach may now apply in the management of shorter duration assets, cash and near cash.
Browsing Vanguard Funds: Where We Have Come From
Five years ago I never imagined that I would be writing three articles within a couple of months about cash management. Events over that period have unfolded in a way that make cash important both for defense (as I discussed in this article) and as an opportunity for risk-adjusted offense. It's like trying to win a Super Bowl with a good defense and a quarterback who isn't flashy but is a good "game manager." It works on some occasions.
I'm mainly an equity investor. I have owned bonds in the past when the coupon return was much higher, but I own no bonds right now except I Bonds. Both stocks and bonds, in my judgment, have pulled forward so much of their future returns that I feel compelled to sit on my 50% equity allocation for now. The question is how best to deploy the other 50% for defense, flexibility, and a bit of risk-adjusted return. It's probably the investing question I currently spend the most time thinking about on a day to day basis.
Recently I have been browsing Vanguard fixed income funds while trying to work out the best strategy for cash and near cash. My initial question was whether to switch from Vanguard's Federal Money Market (VMFXX) to Vanguard Prime Money Market (VMMXX), which has a 20 basis point higher yield, plus or minus. In the process I learned a few very interesting things.
I kept noticing the way Vanguard lays out the returns of each fund over several time periods. It occurred to me that this provides a useful snapshot of where we have come from. It is also a useful instructional guide as to how you can expect the returns on these funds to change as the Federal funds rate changes. The Federal funds rate is the primary benchmark the Federal Reserve uses to raise or lower rates. It has now raised the targeted rate six times in the present cycle beginning in December 2015.
For readers unfamiliar with the Vanguard site I'll give a quick explanation. You just go to Vanguard, click Personal investors, click Investing, click Vanguard Mutual Funds, click Browse Vanguard funds by asset class, and scroll down to see that the above two money market funds are at the top of the list. The analysis I am going to provide derives from data provided conveniently when clicking two options above the individual fund, Portfolio and Management and Price and Performance. You may want to do this for yourself because you may see nuances beyond the things I will talk about in this piece.
Here are the key facts I learned combining tables from these two sections:
The Federal Money Market Fund has a current yield of 1.54%. Its historical returns are 1.02% for one year, .49% for three years, .30% for five years, and .35% for ten years. Its weighted average maturity is 50 days and the weighted average life of its holdings is 88 days.
The Prime Money Market Fund has a current yield of 1.75%. Its historical returns are 1.20% for one year, .64% for three years, .39% for five years, and .44% for ten years. Its weighted average maturity is also 50 days but the weighted average life of its holdings is 107 days.
These facts are shown in both tables and charts under the headings mentioned. A particularly interesting chart is of returns over time which can be clicked to each of the above intervals. It shows that returns were a flat line near 25 basis points, the Fed funds rate for six year before the Fed made the first rate hike in December 2015. There was little to be accomplished by looking at options for short duration cash over that period.
One thing of interest to me was the rapidity with which the funds caught up with changes in the Fed funds rate. Both the reported returns over various periods and the term structure of the portfolios confirm what I noticed anecdotally by frequent checks of the current yield. Their yield closes the gap to the Fed funds rate very quickly after increases, having recently increased by as much as a basis point a day. This happens as the shortest maturities mature and are replaced by maturities at the increased rate. The key takeaway for me was that these funds probably do about as well as you can do by your own effort to ladder.
A small thing I noticed was that the differential between the two funds had been as little as 10 basis points when rates were trivial but was gradually opening out to the 21 basis points at present.
Prime Money Market is not restricted to Federal credits and so would be expected to earn a somewhat higher rate. It is nevertheless quite safe. I actually called and chatted with a Flagship rep to be sure there were no time restrictions for moving fairly large amounts in and out, and there are not. There would be a delay only in the event of a cash freeze up like 2007-8 or greater, and Vanguard did not have a problem with its money market funds during that period. That matters to me because the money market side of the barbell in my portfolio is ready ammo to be used quickly if an opportunity presents itself.
The Federal Money Market Fund is Vanguard's clearance fund, and might therefore be slightly more convenient if the moment arrived to shovel money quickly into stocks. My personal conclusion was to use Prime Money Market as the short end of my barbell in all my family tax-advantaged accounts. Both are convenient and both have zero duration. Because of the ease with which they can be deployed to buy other assets, I put them into the accounts where I would be first to add stocks, stock funds, or even bond funds in a correction.
The Long Duration End Of The Barbell
It may seem odd to think of "cash" as having a duration structure, but I suspect that for most of us it does, reflecting a hierarchy between cash we are likely to need in a hurry and cash not likely to be needed on quite so much of a timetable. My own hierarchy starts earlier, going from actual cash in my wallet to actual cash well hidden to cash in a couple of bank accounts and only then to cash as a cash reserve in Vanguard and Fidelity accounts.
But what is the longest duration which properly serves as a parking place for cash? A paragraph from a recent piece on this site, by The Heisenberg, happened to put into words pretty much exactly what I had been thinking. Heisenberg attributed this view to a "strategist" he knows:
I had a whole system of trading strategies around this pattern in 2006. These are spreads to greens (2y fwds). It's the pure mechanics of the rate hikes. 2y fwd is the terminal Fed. The spread between reds and greens (1y vs 2y fwd) is how aggressively the Fed is going to hike. The spread between blues/greens (3y vs. 2y) is the risk premium (how uncertain the assumption is about greens being the terminal Fed). The two spreads are highly coordinated. As hikes progress, greens are being pinched from both sides - the more hikes the Fed front loads, the less uncertainty about the future.
For what it's worth, as I write this, the 1-year is at 2.09, the 2-year at 2.32, and the 3-year at 2.45. If Heisenberg's strategist is correct, the Fed is not going to hike very aggressively, and the market is fairly sure of this.
To me the key concept was "terminal Fed." I didn't use that term, but 2-year Treasury duration seemed the key number when considering the probabilities around Fed action and the direction of short rates. It's the duration I have been using for several months as the farthest out I would go with cash.
With 2-year Treasuries at 2.32%, a little over two rate hikes away, the implication for me is that two additional rate hikes is the oddsmaker's over/under, with a weak bias for over. The Fed says many more rate hikes are eventually coming, but the market is clearly agnostic about that. Before a fourth rate hike could occur, enough time will likely pass for many events which might change their minds, including various types of political or geopolitical crisis, an inverting yield curve, or distinct warnings of recession.
For that reason the 2-year Treasury is my long end for the barbell. At 2.32% it's not a bad choice for the part of a barbell strategy you want to lock in. If the Fed keeps hiking after two more, the Prime Money Market will track the hikes and eventually become the higher yielding instrument. That's fine. Meanwhile the passage of time will make the 2-year slide down the yield curve toward sharing the yields of shorter term Treasuries.
I'm aware that some of you may prefer CDs for slightly higher return, but I prefer the 2-year because there is a bit more flexibility.
If the Fed goes overboard and causes a recession accompanied by a heavy market correction, historical lead times suggest that I can use the money market funds to begin buying and have plenty of time before wanting to dip into the Treasuries before a bear market bottom is reached. By that time the Fed would be cutting rates.
The two ends of the barbell would be equal - 50/50. The overall yield would be a little over 2% and rising, at least for a while, as the Prime Money Market Fund yield rises along with Fed tightening. You're pretty sure to get at least 2% and probably a bit more.
The Cash Barbell Within My Cash-Heavy Portfolio
One of the major insights from looking at both the tables and the charts included with the Vanguard funds comes from looking at those flat lines of almost no yield from 2010 to 2016. This is why very few people have looked closely at cash return in the recent past. It's high time we all did so.
Cash now offers a very significant risk-adjusted return when compared to either stocks or bonds. The yield on the benchmark 10-year Treasury bond is only 2.80% as of this writing. That's only .48% above the 2-year - thus the often-cited flattish yield curve. Is it really sensible to hold the 10-year at a yield advantage of .48 over the 2-year? Isn't it probable that better safe returns will come along before 10 years have passed?
As for stocks, even taking into account the one-time earnings pop from tax cuts and giving earnings growth the benefit of the doubt, it's hard for me to see more than low to middle single digit nominal returns over ten years. In that context a risk-free return of more than 2% is quite competitive while waiting to see if a better opportunity turns up for buying either stocks or bonds. Cash may be the most reasonably priced asset available anywhere in the markets at a time when most assets seem fully priced.
What About Taxable Accounts?
There's no exactly equivalent strategy in the area of municipal bonds, where a single instrument for the long end of the barbell is not available. It is theoretically possible to put together a muni bond portfolio of short duration, but it requires experience with munis that most individual investors don't have. I am among those who would not feel comfortable trying to do it.
The nearest easy sort-of equivalent might be the Vanguard Limited-Term Tax Exempt Fund (VMLTX) which has a yield of 1.88%. It has a duration of 2.5 years, however, and an average maturity of 3.3 years. That's a little beyond the range of "cash" as I define it. It also lacks the fixity of the 2-year Treasury, where you know exactly what you are going to get.
As it happens, the Vanguard Municipal Money Market Fund (VMSXX) has a yield of 1.40%, the equivalent of a little over 2.20% for the highest income bracket, and pretty good for lower brackets. You can do the math for your own bracket and see if is better than the taxable alternatives.
To me the Municipal Money Market Fund is good enough for family taxable accounts. It provides the equivalent of a more than 2% yield and does it with zero duration. If you look at the tables and the charts of the last 1, 3, 5 and 7 years it also seems clear that its yield will rise alongside increases in the Federal Funds rate. When and if the Fed begins to reduce rates, it will be for circumstances that make me want to get ready to pull the trigger on stocks or stock funds.
Earnings from cash matter again, whether compared to the anticipated longer term returns of stocks or the 2.80% yield of the 10-year bond. A barbell consisting of Vanguard's Prime Money Market fund and the 2-year Treasury makes it highly probable that you will earn 2% or better for at least two years. Those two years are likely to see interesting developments in the market and provide a good interval after which to stop and reassess. At that point other opportunities may begin to present themselves. The Prime Money Market fund alone will probably do pretty well. It serves in the barbell strategy as the more instantly available source of cash, but may end up actually generating the higher return for a while.
In taxable accounts the best strategy is probably a low cost municipal money market fund. There is no single entity with the fixity and safety of the 2-year Treasury.
The above analysis is pretty detailed when you're talking about 20 basis points, but at this point the details matter. There are many ways of coming at the question of cash management, and your idea may be better for you than this one.
The major takeaway is that active thinking about cash management matters now, and those 20 basis points and some strategic thinking involving your estimate of return available elsewhere are well worth your time and attention. If nothing else I hope this article may have an educational effect and prompt some of you to think closely about cash yields and instruments and serve as the starting point of your own research. I am in the process of implementing this strategy, but would welcome suggestions of alternative strategies in the comments section.
Disclosure: I am/we are long VMFXX, VMMXX, VMSXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.