Cash versus bonds: What's best for your clients?
March 10, 2023
March 10, 2023
Many advisors have favored cash and cash equivalents bonds in recent years, fearing the Federal Reserve interest rate-hiking campaign that began in 2022.
The strategy has worked, as cash and very short-duration securities are much less sensitive to interest rate increases. The Bloomberg U.S. 3-Month Treasury Bellwether Index returned 1.51% in 2022, for example, a fraction of the –13.00% drop sustained by the Bloomberg U.S. Aggregate Bond Index, which represents the U.S. investment-grade market.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
But continuing to overweight cash may prove to be another example of how what worked in the past may not work so well again in the future.
With an economic downturn widely expected by markets in later 2023 or early 2024, it may be a good time to reassess how your fixed income portfolio is invested across maturities.
Consider the trade-offs of maximizing yield today by overweighting cash or very short-term bonds in the inverted yield-curve environment compared with moving out the curve to take advantage of yields higher than they’ve been since the global financial crisis and better defend your portfolio from equity weakness.
Of course, the best practice is to align the duration of a portfolio allocation with a client’s approximate timeline, especially if money will be needed relatively soon. For needs within a year or so, cash remains an appropriate option, while short-term bond funds can work well for needs within the next few years.
With higher yields compared with a year ago, bonds can absorb some pain if rates continue to rise without leaving investors with large losses.
For example, the Bloomberg U.S. Treasury 3–10 Year Bond Index, an intermediate-term measure, had a duration of 5.1 years as of January 31, 2023. That means the index could see a 5% price decline if interest rates suddenly rose by one percentage point across the board.
However, if interest rates increased by one percentage point, the higher income component of the index’s return would counter that loss over the next year, leaving a total expected return of –0.51%.
Conversely, if rates were to fall by one percentage point, an intermediate-duration portfolio such as the 3–10 Year Index would be poised to see greater capital gains than a portfolio with a shorter duration such as the 1–3 Year Index, resulting in a 50% larger expected return, 7.75% versus 5.14%.
These hypothetical estimates are based on Treasury rates and do not include the potential impact of credit spread widening or the benefit of higher yields in corporate bonds.
So, what is the matter with staying short?
If interest rates, especially short-term ones, fall, then investors in cash will be faced with the risk of reinvesting at a lower rate, reducing the yield component of future total returns.
In addition, clients whose portfolios are short in duration would miss out on greater capital gains in a scenario where longer-duration bonds also experience yield declines. What’s more, prices on longer-term bonds often rise when equity markets drop as investors seek safety. Therefore, less duration exposure deprives a portfolio of the equity hedge that longer-term bonds can provide in volatile markets.
If your view is that further rate hikes not currently expected by the market may still occur in the near future, short-term bonds may provide a better shield against this risk and still offer highly attractive yields today.
But we believe that what makes sense for most clients is to consider diversifying their fixed income allocation across the maturity spectrum, potentially by moving away from cash-like exposure and toward short-term bond strategies or, for longer investment horizons, to a broad, high-quality strategy like core or core plus.
Here is a sampling of Vanguard actively managed bond funds and ETFs across a range of maturities:
For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
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