As unique asset classes, cash and bonds have some similarities but occupy different spaces within your portfolio. While bonds historically have provided higher returns than cash, today’s interest rate structure is unusual and may impact the conventional wisdom with regard to the optimal balance between cash and bonds in a portfolio. How should investors approach this decision today?
In the past 18 months, the fixed income investment landscape has changed dramatically. Before March of 2022, short-term interest rates had been held at very low levels by the US Federal Reserve since 2008. This meant that for nearly 14 years, yields on cash savings were, essentially, zero. Investors during this period faced an unsolvable paradox: you could have safety of principal, or a positive real yield, but not both at the same time. This era of ultra-low rates even led certain market pundits to declare that “cash is trash” and encouraged many investors to minimize their cash holdings in favor of riskier assets like bonds, real estate, or even equities, where you could still earn a small positive yield.
But, as we’ve seen, nothing in markets lasts forever! In order to combat Covid-era inflation, the Federal Reserve ended its zero-interest rate policy in March of 2022 and embarked on the most aggressive rate hike campaign in decades, taking the overnight lending rate up to 5.33% in short order. The yield one could earn on money market funds and short-term Treasury bills also shifted upwards in concert with the Fed Funds rate. After a painful market adjustment in existing bond prices last year, investors now have many opportunities to earn attractive yields on low-risk cash savings.
In fact, yields are so rich today that investors are having a hard time deciding between cash, short-term Treasuries, and longer-term bonds for their low-risk savings. The “right” choice will only be obvious in hindsight and will depend a great deal on how interest rates evolve from here. Below are some considerations to keep in mind when deciding where to invest excess cash:
- Money market funds are paying very enticing yields on FDIC-insured cash accounts today. It is not unusual to find money market rates of 5% or more if you shop around. The rate you can earn in your money market account is probably higher than on most investment grade bonds that trade today. With inflation running just over 3% year-over-year, investors are able to earn a positive real (after-inflation) yield on their cash for the first time in many years.
- Today’s interest rate environment is unusual – short-term rates are generally higher than long-term rates. In other words, the fixed income market is not presently compensating investors for the additional risk (especially unexpected inflation) in holding long-term debt. All else equal, this argues for shortening the average maturity of a bond portfolio, and for possibly holding more cash than in other periods.
- If the Federal Reserve begins to lower interest rates, money market rates will fall almost immediately. Short-term bondholders would likely see some appreciation in the price of their bonds in this scenario. The effect on long-term bond yields, however, is not predictable. They could fall, stay the same, or even rise in response to FED easing. Bondholders will enjoy capital gains on the price of their bonds if long rates fall but will face losses if those rates climb.
- Longer-term bonds are much more sensitive to changes in interest rates than short-term bonds. For example, interest rates rose sharply in 2022, but the impact on bond prices varied widely depending on the maturity of the bonds. As rates rose, short-term US Treasury bonds (denoted by the purple line in the chart below) fell by 3.9% last year. By comparison, long-term (20+ year) US Treasurys (shown in green) fell 31.1% last year, the worst calendar year return for that asset class in at least a century. The difference in returns clearly demonstrates how much more sensitive long-term bonds are to changes in interest rates.
As evidence-based investors, we understand that the future is unpredictable. When it comes to interest rates, they will either rise, fall, or remain unchanged from here. About the only thing we can say with certainty is what market pricing looks like today. With current yields on cash and short-term bonds higher than the background rate of inflation, and also higher than long-term bond yields, the market is providing an opportunity to earn significant income on low-risk, short-term cash savings. What we don’t know is how long this opportunity will last, or if long-term bonds will ultimately prove to be the better investment.
Sources : https://ycharts.com/