Bonds Versus Money Market Securities: Which Investment is Right for Your Portfolio?
Conservative savers gravitate towards fixed income and credit securities for their supposed safety of principal and interest payments. Bonds and money market investments are important subsets of this group, as they both show markedly less volatility than competing stock market investments.
Still, as an intelligent investor, it is critical for you to appraise structural differences between bonds and money market securities before putting together a diversified portfolio. Here, the term “risk-free” asset is a bit of a misnomer. All financial moves do introduce distinct risks, even when guarantees are apparent.
Debt and Credit
Bonds and money market investments are credit securities. Here, investors lend out money to corporations or government institutions, and collect interest payments until loan principal is repaid in full, at maturity.
For corporations, outstanding debt will appear as a liability on the balance sheet. Interest expense will be accounted for on the income and cash flow statements.
Creditor asset claims are senior to those of shareholders. Corporations are legally obligated to honor principal and interest payments, while cash dividends on stocks are declared and paid out at the discretion of management. In the event of bankruptcy, bondholders and other creditors are to be paid out first, out of any asset liquidation proceeds. For this, credit securities are considered less risky than stocks.
Money Market Securities and Money Market Deposit Accounts
Money market securities are separate and distinct from money market deposit accounts. Money market securities are treated as investments and not guaranteed, while money market deposit accounts are backed by Federal Deposit Insurance Corporation (FDIC) coverage.
FDIC coverage now extends over $250,000 per depositor, per bank. Wealthy depositors will open multiple accounts with multiple financial institutions to maximize FDIC protection.
Banks are not bound to invest money market deposit account cash directly into the money market. Retail clients typically buy into money market securities through money market mutual funds. Money market mutual funds trade for $1 net asset value (NAV) and interest is typically paid out monthly. All interest income is taxed as ordinary income, with 37% levies on the highest bracket.
Loan Maturity Dates
Money market securities are associated with loans that mature in less than one year, whereas bond durations may last into the decades. Shorter maturities translate into less risk within the credit space. To state the obvious, borrowers are far less likely to fail over the next thirty days, as they are to go bankrupt over the next thirty years.
Interest rate risks magnify over time. A long-term bond may lock creditors into accepting 5% interest for thirty years. This same bond would lose significant value, if rates were to sharply increase, and newer bond issues now offer 7% payouts.
Alternatively, a long-term bond will trade at a steep premium if rates were to suddenly weaken. Total returns on bonds include both capital gains (or losses) and interest income.
Money market securities would include treasury bills, certificates of deposit, commercial paper, and securities lending and repurchase agreements, or repos. As a group, money market securities are also described as cash and cash equivalents, for their liquidity and minimal financial risks.
Money market interest rates will closely track the federal funds rate. Amid an inflationary environment, creditors holding short-term debt will immediately roll maturing balances over into newer securities offering higher payouts.
Money market funds took in record $1.4 trillion inflows through 2023, which was more activity than the previous eight years combined. 5% cash emerges as the winning play, with financial markets still grappling with double-digit top-line inflation closing out the COVID-19 cheap money era.
Financial Strategy
Money market securities are best reserved to meet short and intermediate term savings goals. Cash management products should be structured to preserve purchasing power amid inflation.
Your checking account balances provide for day-to-day expenses, while your CD ladder and money market securities generate interest to supplement an emergency fund worth three to six months of committed expenses. From here, you may build towards more ambitious intermediate-term goals, such as a financing a real estate deal or start-up business.
Bonds may be bought as part of a long-term investment strategy – to help you meet retirement or college funding objectives. Retirees, insurers, endowments, and pension funds favor bonds for stable income. The $135 trillion bond market is slightly larger than the much-ballyhooed stock market, and might also be classified according to duration, geography, industry, and credit rating.
Bonds and money market securities are both especially susceptible to opportunity cost risk. Ed from Accounting would have already retired as a multi-millionaire, had he have bought shares of Apple stock, instead of maxing out his 401(k) with bond and money market funds.
A properly diversified portfolio will also include stocks to generate real returns – far above the rate of inflation. Talk to Onyx Investments.