Astronauts are not the only ones interested in escape velocity. Fixed income investors also are talking about this nuanced concept and what it says about moving off the sidelines. Is it time to move out of ultra short-term money market funds (MMF) and reallocate a bit further out on the yield curve? Escape velocity may help answer that question. 

Hiding in MMFs carries risk

Given the volatility and performance of Treasuries during the rising rate environment of the past 18 months, it’s understandable why investors may be reticent to allocate to bonds. For starters, MMF yields have been hovering at their highest level in decades, and investors have been happy to sit tight in these liquid, ultra-short-term funds, which have been paying out more than longer-term bonds given the inverted yield curve.

However, this complacency is not without risk. Remember, MMFs are a type of fixed-income mutual fund and should not be confused with money market accounts, which are typically FDIC-insured bank accounts. In addition, MMFs pay out based on seven-day yields—calculated by distributions paid over the most recent week only. Such yields are not locked in for anything but the very short term, and they can change quickly with any rate movement at the short end of the curve. The anomaly of an inverted yield curve will not last forever, so when these short-term rates change, investors may be looking to reinvest at less-favorable terms. Such reinvestment risk should not be overlooked. 

Understanding escape velocity

Our view for why it may behoove investors to consider reallocating further out the yield curve is informed by the concept of escape velocity, which illustrates how and when bonds can deliver positive returns even if rates rise. Although nuanced, this is a something we believe investors should endeavor to better understand.

Consider this historical example. In 1972, a constant maturity 10-year Treasury fund may have yielded in the neighborhood of 6.4%. With a typical duration of approximately 7.5, a 1% increase in interest rates would have caused a 7.5% decline in the principal of the fund. But remember, this bond fund was also paying 6.4% annually, which helped offset almost all the principal decline. In fact, over the course of the 1970s and despite a doubling in 10-year Treasury yields from 6.4% to 13%, this bond fund would have delivered an average yield of 8.4%. This would have compensated for the duration-related principal losses, and the net result would have been positive nominal returns.

Fast forward to today, and we find ourselves (presumably) late in a rate-hike cycle, with starting 10-year yields approximating 4.3% in early-December 2023. It appears that the Federal Reserve may be approaching its terminal rate (i.e. the near-term peak of its rate hikes, which is 5.5% according to the fed funds futures).  Why does all this matter? Today, many bonds look attractive, in our opinion, given that their higher starting yield should be able to mitigate any commensurate interest rate risk. Thus, the risk-reward scenario for fixed income as an asset class looks favorable, particularly in shorter- and intermediate-term bonds. 

So what's the key takeaway here? Parking cash in money market funds or in the ultra-short end of the curve may not be the best long-term strategy. Rather, there may be intriguing opportunities emerging to add duration to a balanced fixed income portfolio. We believe that short- and intermediate-term bonds—particularly higher quality corporate credits—may actually offer investors a margin of safety against changing rates. 

As the bond market continues to evolve, staying informed about the interplay between yields, duration, and interest rate risk is essential for making sound investment decisions. And right now the nuanced concept of escape velocity suggests that the risk/reward dynamic for bonds is shifting, and it may be time to consider escaping ultra-short MMFs and possibly adding some duration further out on the yield curve.