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The biggest risk you may not know about

Key takeaways

  • Short-term cash investments have grown in popularity since interest rates started rising last year.
  • Those investments may become less attractive as rate increases slow and eventually stop.
  • Bonds with longer maturities may offer higher returns and less reinvestment risk than short-term cash investments as rates stop rising.

Over the past 2 years, many investors have watched yields surge on low-risk CDs, short-term bonds, and money market mutual funds and they’ve found they could earn nearly 5% on their money without the ups and downs that come with investing in stocks.

Now, many of those CDs and other short-term vehicles that investors have put their cash into since interest rates began rising in May 2022 are maturing and owners face the question of what to do next.

Should they stay in cash or is it time to look at longer-term ways to help meet their investment needs with longer-maturity bonds?

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What is reinvestment risk?

While cash is great for maintaining liquidity and flexibility and avoiding the risk of losing money in a market downturn, it is not risk-free. Having too much of it creates its own risks. Possibly the greatest of these risks is that a portfolio with too much cash won’t earn enough over the long term to stay ahead of inflation and that it won’t provide enough protection against inevitable downturns in stock markets.

Those risks may have seemed remote last year when you bought that 1-year CD and the economy was growing slowly but steadily. Now, though, according to Fidelity’s Asset Allocation Research Team, the economy is still growing but a slowdown may be near. That slowdown could come in the form of a “soft landing” in which economic activity diminishes but growth remains positive, or it could look more like a historically typical recession. No one can say for certain, and that increasing uncertainty is something you should consider before you reinvest that money from your maturing short-term CD or bond.

If not cash, then what?

Historically, when the economy slows and eventually enters a recession, interest rates come down. That means that those attractive interest rates on money market funds will also come down. It also means when the short-term CDs and bonds you now own mature, you may be unable to find new ones that pay as much as the old ones did.

Fortunately, you do have an alternative to watching lower interest rates eventually reduce your portfolio’s ability to generate the income you need, and it does not involve investing in stocks. Longer-maturity investment-grade bonds issued by companies with high credit ratings and by governments have historically delivered higher returns than either cash or stocks when the economy is slowing and interest rates are no longer rising. By investing in bonds with maturities of between 3 and 10 years, or in a bond mutual fund or ETF, with durations typically found in the US Aggregate Bond Index, you can avoid the risks posed by holding too much cash, and instead continue to earn the level of return you seek from your portfolio.

Past performance is no guarantee of future results.

What happens to bonds, cash, and interest rates in a slowdown?

As the economy slows, central banks typically cut interest rates in hopes of stimulating an economic recovery and yields on money market funds and other short-term cash destinations come down. While yields on newly issued bonds will eventually also come down along with rates, the interest, or “coupon” that a bond pays remains unchanged until the bond matures or is redeemed by its issuer. That makes it possible for investors in longer-maturity bonds to enjoy today’s relatively high yields well into the future, even after rates come down and short-maturity investment returns suffer. In fact, bonds are the only asset class since 1950 to produce double-digit gains during recessions, providing ballast against equity market declines.

Bond yields follow interest rates and they also move in the opposite direction of bond prices. That means when rates and yields come down as they are likely to as the economy slows, bond prices are likely to rise. Because the total return that a bond delivers to its holder is a combination of the coupon yield and the bond’s price, the combination of potential rising prices in the future and relatively high yields in today’s market could deliver returns that are significantly greater than those available on short-term cash investments.

Keeping your balance

Another potential risk that comes from not reinvesting your maturing cash into longer-term bonds stems from the fact that cash has historically not provided as much protection as bonds from the declines in stock prices that often take place during economic slowdowns. In recessions, it is not unusual for stocks to decline by double-digit amounts. But when stocks have historically sunk, bond prices have often risen by double-digit amounts. While cash did not lose value like stocks during those periods, it also did not gain in value like bonds, which means that the overall value of an investor’s portfolio was more likely to be pulled down by sagging stocks if they had too much cash and not enough bonds.

Time to move?

To be sure, cash still looks attractive right now. According to Fidelity’s Asset Allocation Research Team, the US economy remains in the “late” phase of the economic cycle, in which stock, bond, and cash returns historically have been very close to each other. So far in 2023, bond prices have also been held back by tighter monetary policy. That may make it seem like the time for longer-term bonds has not yet arrived, but financial markets are constantly in motion and they don’t tell investors what they may do next. That makes it nearly impossible to pick the perfect moment to reinvest your cash into bonds, so investors who stay in cash now may risk missing their opportunity.

Fidelity can help you find the right mix of cash and investments

Professional investment management services such as those offered by Fidelity's managed accounts do not allocate large amounts of money to cash. Instead, they stay invested and follow a long-term investing plan. Fidelity offers a wide variety of research tools to help you reduce the risks posed by staying too long in cash.

We also can help you create a plan to manage risk in your portfolio and can even help manage that portfolio by looking at your timeline, goals, and feelings about risk to create a mix of investments that’s right for you.

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This information is intended to be educational and is not tailored to the investment needs of any specific investor.

The views expressed are as of the date indicated and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments. The experts are not employed by Fidelity but may receive compensation from Fidelity for their services.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.

Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Your ability to sell a CD on the secondary market is subject to market conditions. If your CD has a step rate, the interest rate of your CD may be higher or lower than prevailing market rates. The initial rate on a step rate CD is not the yield to maturity. If your CD has a call provision, which many step rate CDs do, please be aware the decision to call the CD is at the issuer's sole discretion. Also, if the issuer calls the CD, you may be confronted with a less favorable interest rate at which to reinvest your funds. Fidelity makes no judgment as to the credit worthiness of the issuing institution.

Lower yields - Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk.

Interest rate risk - Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline.

Call risk - Some Treasury securities carry call provisions that allow the bonds to be retired prior to stated maturity. This typically occurs when rates fall.

Inflation risk - With relatively low yields, income produced by Treasuries may be lower than the rate of inflation. This does not apply to TIPS, which are inflation protected.

Credit or default risk - Investors need to be aware that all bonds have the risk of default. Investors should monitor current events, as well as the ratio of national debt to gross domestic product, Treasury yields, credit ratings, and the weaknesses of the dollar for signs that default risk may be rising.

You could lose money by investing in a money market fund. An investment in a money market fund is not a bank account and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Before investing, always read a money market fund’s prospectus for policies specific to that fund.

Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

Past performance is no guarantee of future results.

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