As the Federal Reserve continues its fight to slow the pace of inflation, yields available on cash instruments have become increasingly attractive. After raising short-term rates by 5% since March of 2022, cash yields are the highest they have been in over 15 years. Following one of the worst-ever returns for the bond market last year, many investors are questioning whether it makes sense to ditch bonds altogether in favor of cash. There are a few compelling reasons investors should feel confident retaining their bond exposure.

To start, bonds have historically rewarded investors with a higher return than cash. The chart below illustrates the growth of $1,000 invested in 5-year Treasury bonds versus 1-month Treasury bills (cash), going back nearly 100 years. During this period, cash returned an annualized 3.2%, while bonds returned 4.9%. When allowed to compound for an extremely long period, the ending values of the initial investments are dramatically different. The value of the bond investment grew to be nearly 5x greater than the cash investment.

Most people will not have an investment horizon that spans a full century and should, therefore, not expect their bonds to return 5x more than cash. The extremely long period was selected to incorporate as many different cycles of rising rates as possible. Even through all the different periods of tight monetary policy, bonds maintained their advantage. Compounding that advantage across a couple of decades would result in meaningfully more wealth for the bond investor.

Source: Morningstar Direct. Returns are annualized from Jan 1926 through May 2023. Cash is represented by the IA SBBI 30 Day T-Bill USD TR Index, bonds are represented by the IA SBBI US IT Gov Bond TR Index.

Over the last year and a half, expected returns for bonds have increased alongside cash. The return on a fixed income portfolio, which can be comprised of both cash and bonds, is driven by a combination of:

1. Change in principal value
2. Interest income

Since the principal values for these investments are typically relatively stable, the interest produced tends to drive the bulk of the total return. As a result, a fixed-income portfolio will have a return that is highly dependent on its starting yield.

When yields rise and fall, the income-producing potential and, therefore, the expected return follows suit. Given the large uptick in rates, expected returns for cash and bonds going forward have both increased dramatically.

A major difference between cash and bonds emerges when you examine the reaction of their principal values to a change in yields. Fixed income prices move inversely with yields, and the magnitude of those price changes is dependent on interest rate sensitivity. Generally speaking, interest rate sensitivity increases as the length of time till maturity is increased. 

Over the last year, the principal value of bonds has experienced a notable drop. Cash, on the other hand, has essentially been unaffected due to its ultra-short term to maturity.  So why would any investor want to hold bonds, which could see further principal declines if long-term rates continue to rise? There are a couple of compelling reasons:

1. Bonds tend to outperform cash over the long term, regardless of interest rate moves.
2. Bond investors have already endured near-term pain associated with a large uptick in rates.
3. Yields were near zero when rates began to rise, providing very little income to offset the subsequent price decline. With yields much higher today, there is meaningful income being produced to offset a principal decline caused by further increases.
4. There is always the possibility that yields reverse course and begin to decline.

Most people consider falling interest rates to be a positive for fixed-income portfolios, but this view is warped by short-term thinking. While some holdings may see their prices appreciate as yields decline, the fuel for their future expected returns (interest income) is also declining. This is especially troublesome for cash.

Within a bond allocation, the loss of future income caused by a decline in yields is offset by some 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. This creates substantial risk to shifting the entirety of a bond allocation to cash. If rates were to fall, cash investors would be left with essentially nothing to show for it.

Week in Review

• Congressional testimony by Fed Chairmen Jerome Powell last week suggested the likelihood of additional rate hikes to come this year following the decision to pause at the June meeting. The fed fund futures market is pricing in a 77% chance for a hike at the net meeting in July.
• Economic data published early this week showed a rise in consumer confidence, an increase in durable goods orders, and a continued decline in home prices.
• Economic data to be published later this week includes a revision to first quarter GDP, initial jobless claims, and the Personal Consumption Expenditures (PCE), which is the Fed’s preferred gauge of inflation.

Hot Reads

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• Markets Are Pricing In Rate Cuts Too Soon, IMF’s Gopinath Says (CNBC)

Investing

• Why You Believe The Things You Do (Morgan Housel)
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• The Bulls Are Back in Town (Nick Maggiulli)                                         

Other

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• How Your New Car Tracks You (Wired)

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

IMPORTANT DISCLOSURE INFORMATION