Should You Hold Cash Instead Of Bonds Right Now? (EP.109)

0:28We all need to make smart decisions with our money. doesn't mean they can't lose money. In fact, 2022 was the worst year for bonds in U.S. history. I've noticed an increasing number of people wondering whether they should hold cash instead of bonds. Generally, short-term instruments such as money market funds are appropriate for cash reserves or emergency funds, whereas CDs and short-term T-bills, whether they're one-month or three-month or six-month T-bills, are most appropriate to use when the term of the securities is matched with a future liability, whether that's a down payment on a home, a major purchase like a car or renovation, a large business expense, etc.

1:09But in all cases, cash has risks, most notably reinvestment risk. Reinvestment risk is the possibility that you have to reinvest an investment's cash flow at a lower rate. Vanguard produced a nice graphic recently that I'll include in the show notes at thelongterminvestor.com that predicts a hypothetical 5.09 % rate on a three-month treasury bill, which is a touch lower than where it sits today, but it's close enough for our purposes. When you see a three-month treasury bill yielding 5.09%, that's an annualized rate. You actually only earn 1.25 % over the three-month period. To earn that full 5.09 % over the course of a year, you must reinvest the interest in principle from your maturing three-month T-bill into a new three-month T-bill that is also paying a 5.09 % annualized yield.

2:06Then three months later, you have to do the same thing, and then again in three more months. Now, assuming that rates stay exactly the same throughout the entire year is pretty unrealistic. Rates fluctuate all the time. Cash products and the shortest-term treasuries tend to track the Fed funds rate pretty closely, so if the Fed cuts interest rates at some point, your return will be lower. Now, it's impossible to know when the Fed will stop hiking rates or begin cutting rates. The Fed themselves doesn't even know. But once they do, cash will lose its luster. The consensus viewpoint is that the Federal Reserve will raise interest rates two more times by the end of 2023.

2:48three. Now, whether that will be the end of this rate hiking cycle is anyone's guess. But historically, cash products have trailed bonds in the 12 months after the end of a Fed rate hiking cycle. There's another graphic from Vanguard that I'll share in the show notes at the longterminvestor.com if you're interested in seeing the data yourself. But I think it's sometimes useful to go back to the very basic principles of why we invest in the first place, which is to grow our savings faster than inflation. Investing in cash is not useful from that perspective. In fact, after inflation and taxes, the return on cash is negative.

3:30That's why cash should be kept to a minimum in your portfolio. Now, outside your portfolio, there's lots of good uses for cash and similar products, such as money market funds, CDs, and ultra short-term treasury bills. But for long-term investors, bonds are a much better asset class to offset the volatility of your stocks while delivering a return above the rate of inflation. Now, if you are looking for higher yields, don't forget that the bond market offers lots of options. In the show notes, I've plotted U.S. Treasury yields versus U.S. investment-grade corporate bond yields. And what you'll see is that unlike the inverted treasury yield, which is just another way of saying that short-term yields are higher than long-term yields, the investment-grade corporate bonds have higher yields across all maturities to reflect the higher credit risk.

4:21As a result, investors can lock in higher yields on longer-dated investment-grade corporate bonds than treasuries of the same maturity. And even though corporate bonds are expected to carry higher risk of default than treasuries, it's important to recognize that default rates have historically been low among investment-grade corporate bonds. Plus, diversifying across multiple yield curves in multiple countries using bond funds further reduces the risk of any single corporate default having a material effect on your portfolio. Look, if you could precisely time interest rate changes, then going to cash now and switching to bonds at just the right time would obviously be profitable.

5:03Most, if not all, people acknowledge that such market timing is impossible in the stock market. But for some reason, people forget about the difficulty of market timing when it comes to discussing cash versus bonds. Holding cash outside your portfolio for short-term spending needs or an emergency fund makes perfect sense. But cash and cash equivalents should be minimized in your portfolio because they deliver negative real after-tax returns. And they certainly shouldn't replace bonds just because they might offer high yields at this very moment in time. As always, you can find resources, links, and all sorts of other great stuff in the show notes at thelongterminvestor.com.

5:49And while you're there, be sure to sign up for my newsletter that comes out every other Wednesday has links to all sorts of great resources to help you make better choices with your money. As always, thanks for listening. And until next time, to long-term investing.

6:21Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.