Ultrashort Bonds vs. Cash: Understanding the Trade-Offs

Cash-Equivalent Yields Are Falling — So What?

Many investors keep money in cash equivalents — such as certificates of deposit (CDs), Treasury bills and money market accounts — for their liquidity and quality benefits.

In recent years, these instruments offered attractive yields that outpaced inflation, as shown in Figure 1. The result? Investors could generally maintain purchasing power.

Today, that may no longer be the case, as lower yields can make it harder for cash holdings to maintain purchasing power.

Since late 2024, when the Federal Reserve (Fed) launched a rate-cut campaign, yields on many cash investments declined. As a result, cash equivalents began generating less income than in prior years.

In addition to lower income levels, other factors should be considered.

Taxes can further reduce that income, while inflation can diminish its purchasing power. Interest from many cash equivalents is typically taxed as ordinary income, although tax treatment varies by investment and investor. At the same time, persistent inflation increases the cost of everyday expenses, gradually reducing what those cash holdings can buy.

Understanding the Impact of Taxes and Inflation on Cash

Suppose a $1,000 cash investment earns 3% annually, generating $30 in interest over one year. Taxes may further reduce that income, depending on the investment and the investor’s tax situation.

If inflation is also 3%, rising prices may offset much of the purchasing power from that interest. The account balance increases, but the money may buy little more than it did a year earlier.

Ultrashort-maturity bonds may offer higher income potential than cash equivalents, although their values can fluctuate and they carry additional risks. Because their maturities and durations are typically short, they may be less sensitive to interest-rate changes than longer-maturity bonds.

Why Cash-Equivalent Yields May Stay Low

Cash equivalents typically move in tandem with the federal (fed) funds rate. This is the interest rate set by the Fed that banks charge each other for overnight loans.

Yields on cash equivalents rose to multidecade highs after high inflation prompted the Fed to raise rates in 2022. When the Fed later paused and began cutting rates, cash-equivalent yields declined.

If interest rates remain near current levels, cash equivalents may continue to generate less income than they did in recent years.

Why the Fed May Hold Rates Near Current Levels

Cash-equivalent yields may change little in the near term. Although the Fed has shifted to a tightening bias, we don’t believe this marks the start of an extended rate-hike cycle.

Here’s why we think the Fed may be content to keep the fed funds rate close to its current range of 3.75% to 4% in the near term:

• While inflation, measured by the Consumer Price Index (CPI), remains above the Fed’s 2% target, it has moderated from prior highs, as Figure 2 illustrates.

• The labor market has remained fairly stable.

• The economy has continued to grow.

What’s Driving Higher Bond Yields?

While Fed policy has influenced Treasury bill and other cash-equivalent yields, market forces have pushed bond yields higher across the yield curve. These forces include:

• Resilient economic growth

• Persistent above-target inflation

• Less forward guidance from the Fed

• Growing federal debt

• Increased corporate bond issuance, particularly among artificial intelligence (AI)-related companies

These conditions may contribute to higher yields on ultrashort- and longer-maturity bonds than on cash equivalents. However, unlike cash equivalents, ultrashort bond funds can fluctuate in value and carry additional risks.

Ultrashort bonds have provided higher average yields than three-month Treasury bills over time, as Figure 3 illustrates.

Why Interest Rate Volatility Remains Elevated

Interest rate volatility, as measured by the ICE BofAML MOVE Index, has been elevated in recent years. Higher index readings generally indicate greater uncertainty about the direction of interest rates.

As of July 31, 2026, the index’s five-year average was 99, compared with an average of 67 over the preceding 10 years, as shown in Figure 4.

Following his first policy meeting as Fed Board chair, Kevin Warsh reiterated his skepticism of central bank interest rate forecasts. Consequently, he didn’t participate in the Fed’s quarterly dot plot, which shows each Fed Board member’s individual outlook for interest rates.

Less forward guidance from the Fed could contribute to continued uncertainty about the path of interest rates, potentially keeping bond market volatility elevated.

Ultrashort vs. Money Market Funds: What’s the Difference?

Investing for income often involves comparing money market funds with actively managed ultrashort bond funds. Ultrashort bond funds generally hold securities with very short maturities and maintain durations of less than one year.

Compared with money market funds, ultrashort bonds may offer:

• Higher yield and income potential

• Greater flexibility to pursue opportunities across government, corporate and securitized issuers

• Greater sensitivity to interest rates, credit conditions and changes in market value

Figure 5 outlines the key characteristics of the two types of funds. Money market funds seek to maintain a stable $1 share price, while ultrashort bond fund share prices fluctuate. Ultrashort bond funds also generally carry higher interest rate and credit risk, though their ultrashort maturities may help mitigate these risks.

What Happens to Ultrashort Bonds When Rates Change?

Bond prices generally move in the opposite direction as interest rates. When rates rise, existing bond prices typically fall, and when rates decline, existing bond prices typically rise.

Duration helps estimate the potential magnitude of those price changes and their effect on total return. All else equal, bonds with longer durations generally experience greater price changes — and a larger effect on total return — than bonds with shorter durations.

Because ultrashort bond funds have relatively short durations, they generally experience less price movement when interest rates change than intermediate- and long-maturity bond funds. However, their share prices and total returns can still fluctuate.

Income from a fund’s underlying bonds may help offset interest-rate-related price declines. As the hypothetical scenario in Figure 6 illustrates, even with a half-point move in interest rates, the potential total return range remains tight due to the short duration.

Key Considerations for Investors Holding Cash

A less predictable path for Fed policy could contribute to continued volatility in interest rates. With less forward guidance, financial markets may respond more directly to incoming economic data, which can change unexpectedly.

In this environment, investors may compare the income potential and risks of cash equivalents with those of ultrashort- bond funds. Ultrashort bond funds may offer higher yield potential than cash equivalents and less interest-rate sensitivity than longer-duration bond funds. But ultrashort bond funds also carry greater interest-rate, credit and share-price risk than cash equivalents.

In our view, actively managed ultrashort bond funds may offer compelling income opportunities across a broad mix of short-maturity securities.