When interest rates are rising and the stock market is in the doldrums it is often easy to sit on a substantial cash position on the theory that your interests are being well served by holding cash and waiting for rates to rise. While this may work sometimes, unless there is a very rapid upward movement in rates, it’s usually better to make short, conservative bond investments rather than wait out the rise in rates. Let’s look at an example.

As I write this a typical money market account might pay you something in the vicinity of 1.5%, and I’m being generous. Alternatively, today you can also buy a two year treasury note that pays 2.5%. Let’s assume the Fed raises rates a total of 2% over two years in 25bp increments every quarter. Which is the better strategy, hold cash in a money market account that immediately captures the rate increases or buy a bond that pays you more up front? Ignoring the effects of compounding, the actual income earned would look like this:

                                MONEY MARKET             TWO YEAR TSY NOTE

Interest Q1                       $375                                        $625

Interest Q2                         438                                         625

Interest Q3                         500                                         625

Interest Q4                         563                                         625

Interest Q5                         625                                         625

Interest Q6                         688                                         625

Interest Q7                         750                                         625

Interest Q8                         813                                         625

TOTAL INTEREST           $4,752                                     $5,000

Owning the two year treasury note produced the better return. The fact of the matter is that the extra income you earned in the first year more than offset the higher income that eventually accrued to the money market account. Had we factored the compounding on the higher interest it would have even further favored owning the note. Furthermore, a two percent increase in interest rates over two years is a fairly dramatic move so if the rise were slower or of a lesser amount the advantage to owning the bond would be even greater.

To be sure a rapid rise in rates will favor the cash holding but all indications at the moment suggest the Fed will not move either very quickly or far from where rates are today. In my opinion this is an excellent time to invest your excess cash in short maturity notes. Unless rates rise much faster than anyone expects and as long as you can hold your position to maturity you will very likely come out far ahead by buying a short maturity note or bond. This advantage can be even further enhanced buy utilizing high quality agency or corporate bonds. As always, this advice won’t work for everyone so examine your personal situation to see if it is appropriate and please feel free to call me if you have any questions.

Randy Gridley

October, 2004