The siren song for money market funds has become a little louder: With the timing of Federal Reserve rate cuts shaky, yields on cash are still hot — for now. After central bank policymakers last week highlighted a “lack of further progress” on tamping down inflation, Wall Street responded with widely varying expectations on the number of expected rate cuts in 2024, ranging from as few as one to as many as four. It also means that, at least in the short term, investors hiding out in cash are getting paid well to do so: The Crane 100 Money Fund Index is showing an annualized seven-day current yield of 5.13% as of May 8, and Bread Financial is offering a one-year certificate of deposit with an annual percentage yield of 5.25%. But those who sock away too much of their money in these cash deposits run the risk of missing out on expected price appreciation in bonds once the Fed starts dialing back rates. “Once the Fed cuts rates, yields on money market accounts will fall very quickly,” said Rob Williams, managing director of financial planning at Charles Schwab. Here’s how to decide where and when to redeploy some of your idle cash into fixed income. A gut check A general rule of thumb in financial planning is to have at least a year’s worth of expenses in readily accessible cash, but earmarking any sums over that amount will require you to review your goals and your portfolio’s asset allocation. “Figuring out where to put that first dollar comes down to what the individual is willing to achieve,” said Ashton Lawrence, a certified financial planner and senior wealth advisor at Mariner Wealth Advisors in Greenville, South Carolina. “Things people may want to take into consideration, whatever they invest in, is how rate sensitive is that next dollar going to be.” Key factors to weigh as you decide where to redirect some of your cash include interest rate sensitivity, credit risk and liquidity, he said. Duration — a bond’s sensitivity to interest rate changes — is also a focal point. Bonds with longer maturities tend to have greater duration, but they may also see the most dramatic price swings when rates fluctuate, compared with their short-duration counterparts. Diversification is also important. “Spread your fixed income investments across various sectors, such as government, corporate and municipal bonds, as well as different maturities,” Lawrence said. Taxes are also a key consideration as you build out your fixed-income sleeve. The interest you receive on corporate bonds, CDs and money market funds is subject to ordinary income taxes, which can be as high as 37% depending on your tax bracket. Interest income from Treasurys, meanwhile, is subject to federal income tax but exempt from state and local taxes. Municipal bonds offer tax-free income at the federal level and may also be exempt from state levies if the investor resides in the issuing state. The savings are especially significant for high-income investors in high-tax states, including New York, New Jersey and California. The tax treatment of fixed-income investments is also a factor in which accounts ultimately hold those assets. For instance, corporate bonds and the funds that hold them could be good contenders for tax-deferred accounts, but municipal bonds are better suited for taxable brokerage accounts since there’s no need to shield them from taxes. “Highly rated munis with short maturities in taxable brokerage is something we like for investors in higher tax brackets,” Williams said. A gradual entry toward fixed income You don’t have to build out your fixed-income allocation in one day. For investors who are just starting to get comfortable with the idea of adding duration, laddering CDs or Treasury bills could be a good first step, Williams said. These ladders involve buying a portfolio of fixed-income investments with different maturities, and then as those assets mature, you can reinvest the proceeds into a longer-dated instrument. You can also dollar-cost average into fixed income and build those positions incrementally. “This can involve saying, ‘Each month, each quarter, each year, I put this much into a growing allocation to bonds,'” said Williams. Dollar-cost averaging into a diversified mutual fund or ETF also allows investors to get exposure to fixed income easily, as opposed to buying individual bonds. Lawrence likes the idea of using individual bonds to build out fixed-income sleeves — as investors holding to maturity don’t have to worry as much about price fluctuations in the interim. But for those inclined toward bond funds, he prefers active management over passive. “Mutual funds can be an efficient way to pick up diversification, but I would lean more toward active management,” he said. “An active manager can strip out the ugly piece of the index and outperform in that regard.”
