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.