The fixed income/bond marketplace looks to be approaching a time of so-called “Normalization” as interest rates adjust from higher inflation levels to lower inflation.  The “higher for longer” mantra is giving way to a lower interest rate environment as the Federal Reserve’s restrictive monetary policy is pushing the inflation rate down closer to their 2% target.

This change has broad market implications for stocks and bonds, and this includes changes for money market funds.  Money market funds, with yields above 5%, have been a refuge in the recent past during a difficult period for the fixed income bond market.  Money funds positive total return investment performance compares very favorably to the Bloomberg Aggregate index, and especially compared to long-maturity US Treasury bonds.  The reality is that money market funds significantly outperformed other fixed income asset classes as shown below:

Despite recent favorable money market performance, the fixed income bond world is changing as the Federal Reserve (which had amped up short-term rates to battle inflation) is now expected to begin reducing rates in September.  At this time, the market expects three rate cuts in 2024 that would drop short-maturity interest rated by 0.75% by yearend.  Moreover, an additional four cuts are expected next year, resulting in short rates ending year-end 2025 at around 3.5%.  These rate cut expectations could certainly be altered depending on upcoming inflation, employment and other economic data. 

Money market rates will be negatively impacted by this expected Fed rate-cut cycle.  While money funds have minimal risk of losing value, they are subject to re-investment risk as their maturing holdings will need to be replaced with lower yielding assets.  At this point, money market fund 7-day yields are slightly above 5%, but they are likely to gradually fall towards the 3.5% level by later in 2025.  Ultimately, money market yields should normalize marginally above the inflation rate/consumer price index. 

Although interest rate forecasts are notoriously difficult to get right, the downward rate trend appears likely.  It is noteworthy that there is a tremendous amount of money ($6 trillion in money market accounts) sitting on the sideline.  As investors look at broker statements and realize they aren’t getting 5% yields anymore, there will be a need for relatively safe, conservative funds with higher yields.

The superior money market performance over the last three years was the result of the Federal Reserve’s tight-money policy to push up short-term rates to reduce inflation.  Before that, the Fed had maintained a  free/easy money policy (Zero Interest Rate Policy-ZIRP) to stimulate the economy reeling from the Great Financial Crisis and then the COVID pandemic. 

While MM funds had a positive yield premium in the recent past, this was an anomaly compared to history and this premium is going away.  It was a good ride while it lasted, but markets change and there is a need to adapt.  It should be noted that strong relative money market performance in recent years is not typical, and yields were near 0% for most years between 2009 through 2021.

Although money market rates in the mid 3% range could still be acceptable (especially compared to minuscule bank checking account rates), there are alternatives that are expected to earn higher returns.  Key criteria for alternatives are based on shorter-maturities (to mitigate against price volatility if inflation proves to be higher than expected) and higher credit quality (to mitigate against the risk of recession).  These Exchange Traded Funds have daily liquidity and are relatively conservative.

A couple Exchange Traded Funds-ETFs offering potentially better returns than money funds include the Invesco Ultra Short Duration ETF-GSY and the JP Morgan Limited Duration Bond ETF-JPLD.

Invesco Ultra Short Duration ETF-GSY 

60% investment grade corporate bonds, 40% securitized and cash equivalents.

Morningstar Rating-4 Stars and a Bronze analyst rating.

Expense Ratio = 0.23%.

Credit Rating = A+.

Duration = 1.69, which is relatively short.

Morningstar Risk Rating-Conservative = 2 on a 100-point risk scale.

JP Morgan Limited Duration Bond ETF-JPLD

87% securitized mortgage and asset-backed securities,

Morningstar Rating-4 Stars and a Gold analyst rating.

Expense Ratio = 0.24%.

Credit Rating = AA+.

Duration = 0.69, which is quite short.

Morningstar Risk Rating-Conservative =  6 on a 100-point risk scale.

While these two ETFs have modestly higher risk characteristics than money funds, they are expected to generate returns above the reinvestment risk of money market funds.  These two ETFs provide some diversification benefits because the Invesco fund holds 60% investment grade corporate bonds and would be negatively impacted by an economic recession.  Meanwhile, the JP Morgan fund has minimal credit risk, but it might be negatively impacted by a disrupted mortgage market as we saw in 2022. 

As always, there is no assurance that these funds will outperform money market funds in the future. 

On a monthly basis, they may post negative performance, but they are expected to outperform money market funds on a longer 12-24 month time horizon.

Cornerstone exists to provide educational investment information with a Christian perspective. Some posts are purely about investments (like this one), but other posts have covered Christianity and Civilization, stewardship and charitable giving, core values and ESG, Happiness/Money, etc. This is a unique combination, and Cornerstone continues to evolve. Your comments are always helpful and are appreciated.

Jeff Johnson, CFA

August 18, 2024