Bonds or Cash? + 6.5.24
The Federal Reserve began signaling its intention to tighten monetary policy late in 2021. Since that time, the Bloomberg Aggregate Bond Index (Agg), a popular proxy for the US bond market, has been under serious pressure. Bonds got a reprieve in 2023 as faster-than-expected progress on lowering inflation put the focus on potential rate cuts. The Agg returned 5.5% last year, narrowly outperforming cash. Hotter-than-expected inflation data early this year has once again put bonds under pressure, as the Fed has signaled that rates will likely need to remain “higher for longer.”
As we enter the summer months, bonds have generated a slightly negative return year-to-date. Meanwhile, cash is still yielding north of 5%. In light of this, we’d like to revisit whether it still makes sense to own bonds.
We believe bonds play a critical role in a diversified portfolio, and the recent volatility experienced in the bond market, while uncomfortable, has not changed that. Bonds provide a crucial ballast to equity holdings. They usually offer a very low, or even negative, correlation to stocks. This means that when one of the two zigs, the other often zags. The result is a risk and return profile that generally becomes more stable as the proportion of bonds to stocks increases. Combining these two asset classes allows an investor to calibrate the riskiness of their investments to match their unique situation.
Fortunately for investors, short-term pain in the bond market can lead to long-term gains. The benefit comes from the fact that bondholders get to reinvest their ongoing interest payments at the increased yield levels. With a sufficiently long holding period, the ability to reinvest at higher rates will more than compensate for the initial decline in value. This is why bonds are sometimes referred to as the “self-healing” asset class.
As the chart below illustrates, the relationship between changes in yield and the future return on bonds is quite strong. The blue line represents the yield on 5-year Treasury bonds going back to the start of 1962. The green line represents the annualized return over the subsequent five years. While the lines are not perfectly in sync, they are clearly very closely tied to each other. As the yield line rises (falls), the return over the next five years also increases (decreases). The recent rise in the blue yield line sends a strong signal that the prospect for the green return line is also rising.
Source: Morningstar Direct & the FRED database. The Yield is based on the Market Yield on U.S. Treasury Securities at 5-Year Constant Maturity, quoted on an investment basis. The 5-Year Forward Return is based on the IA SBBI Intermediate Term Bond Index.
Most people believe falling interest rates are an unqualified positive for fixed-income portfolios, but this view is warped by short-term thinking. While bond prices appreciate as yields decline, the fuel for their future expected returns (interest income) is also declining. Over a sufficiently long holding period, the investor will ultimately be worse off after rates fall. This may be a negative for bonds, but it’s disastrous for cash.
Within a bond allocation, the loss of future income caused by a decline in yields is mitigated by a combination of price appreciation and the ability to lock in a higher interest rate until the bond matures or is sold. Cash has little to no ability to lock in higher rates or appreciate as yields fall. Shifting the entirety of a bond allocation to cash is, therefore, a much riskier proposition than it appears at first glance. When rates eventually fall, cash investors will be left with essentially nothing to show for it.
Week in Review
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Data released last Friday showed that Core PCE, the Federal Reserve’s preferred inflation measure, rose 0.2% monthly and 2.8% over the last twelve months. The 0.2% monthly gain in Core PCE is the smallest monthly increase since December of 2023.
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The April Job Openings and Labor Turnover Survey (JOLTS) was released Tuesday (6/4), it showed job openings in April declined 296,000 from the prior month to a total of 8.06 million, the lowest amount of job openings in three years. The survey showed that the biggest declines were seen in health services, with job openings falling by 204,000, followed by “state and local government education,” with 59,000 fewer job openings than the month prior.
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According to FactSet, 98% of the S&P 500 has reported Q1 2024 results as of last Friday, May 31st, 2024. The earnings growth rate, blended between companies that have already reported with the estimates for those that have yet to report, is at 5.9% year-over-year, which is above analyst expectations of 3.4% going into this earnings season. FactSet also reported that earnings estimates for next quarter (Q2 of 2024) have increased by 0.3% during the first two months of this quarter. This is atypical relative to recent history, as the average decline in EPS estimates during the first two months of a quarter has been -2.4% the past 15 years.
Hot Reads
Markets
- Job Openings Fell Again in April, Hitting Lowest Level Since February 2021 in a Sign of Labor Market Weakening (CNBC)
- The Fed’s Preferred Inflation Measure Rose 0.2% in April, as Expected (CNBC)
- 10-Year Treasury Yield Continues June Slide on Signs of Weak Labor Market (CNBC)
Investing
- When Past Performance Doesn’t Even Predict Past Performance (Jason Zweig)
- Big Tech Companies Unplug Stock Market From Reality (WSJ)
- The Relationship Between Wages & Inflation (Ben Carlson)
- The Etiquette of Unexpected Phone Calls Divides Friends, Families, and Co-Workers (WSJ)
- U.S. Open 2024: Ranking the Top 10 Golfers Without a Major (Golf Digest)
- Inside the Chornobyl Exclusion Zone (2014) – 60 Minutes (YouTube)
Markets at a Glance
Source: Morningstar Direct.
Source: Morningstar Direct.
Source: Treasury.gov
Source: Treasury.gov
Source: FRED Database & ICE Benchmark Administration Limited (IBA)
Source: FRED Database & ICE Benchmark Administration Limited (IBA)
Economic Calendar
Source: MarketWatch
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