We were recently asked by a foundation to quantify the cost of sitting in cash (money market) with a $1mm portion of their fixed income portfolio. The foundation assumed that rates would be going up starting in 2010, and that one alternative would be to buy a 3 year agency bond with a one time call which would occur 12 months from now...often described as a 3yr/1yr 1x call. Is it better to sit in cash and wait for rates to rise, or is it better to get invested now in what could be a rising interest rate environment?
We assumed that money market rates were 1/4% and that starting in 2010, money market rates would increase by 25basis points (1/4 of 1%) every quarter for the next three years. We also assumed that the market could give us a 3yr/1yr 1xcall Agency bond at 2.00%.
At the end of 12 months, sitting in cash (even with rates rising) has cost the foundation $15,625. At this point, if the bond gets called, the foundation will need to reinvest in another bond. If the bond does not get called, the foundation will hold the bond for another 24 months. At the end of that next 24 months, even with rising rates, sitting in cash has cost the foundation a total of
Unless one thinks that rates are going to increase dramatically in a very short period of time, the cost of sitting in cash is too high. If the interest rate curve were flatter, it might make sense. But, with low money market rates combined with very attractive 3 and 5 year bond rates, it pays to grab some of those yields right now.