By Kevin J. DiCiurcio, CFA; Lucy Momjian, CFA
US institutional investors are increasingly considering the trade-offs between money market funds and short-term bond vehicles for the management of their liquidity reserves. The trend is a reflection of possible liquidity and accounting implications of money market reform due to take effect fully in October 2016, and concerns about the interest rate outlook.
This paper evaluates these trade-offs by integrating both a historical return analysis and forward-looking simulations using the Vanguard Capital Markets Model® (VCMM). We consider the historical relationships of several fixed income options as well as the impact of the current low short-term interest rate environment.
Although noting both the historical outperformance and the forecast higher expected returns of ultra-short- and short-term bond funds versus money market funds, our analysis suggests that investors who accept the additional interest rate and credit risk materially increase their probability of loss of principal. We furthermore observe that moving from a money market fund to an actively managed ultra-short- or short-term bond fund increases manager uncertainty due to the broader opportunity set of investments.
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Notes:
- All investments are subject to risk, including possible loss of principal.
- Diversification does not ensure a profit or protect against a loss.
This article was produced by Vanguard and not by the Quartz editorial staff.