As short-term rates continue to rise and the yield curve flattens, some may ask, “why not simply hold cash instead of investing in bonds?” Cash yields are higher than they have been in over a decade, even as rising rates have pushed down bond prices, leading to negative returns over the past year.
While current cash yields may seem attractive, we still believe that an allocation to core fixed income remains preferable to holding cash from a long-term investment perspective. As illustrated above, core bonds tend to be a superior diversifier to equities. In general, bond yields are higher than cash yields, providing compensation for investors willing to take that incremental risk and hold bonds until they mature. Additionally, high-quality bonds typically perform better during equity downturns, providing some protection in a diversified portfolio and helping to offset temporary declines in equity values. Cash will hold its value in such circumstances, but cannot have that same inverse relationship.
Moreover, actively managed core bond portfolios have the flexibility to adjust the positioning of their portfolios to protect against risk and take advantage of opportunities that arise in the market, creating the potential to add value beyond a simple “buy and hold” strategy. The vast majority of a bond portfolio’s returns come from coupon payments, not price appreciation. While rising rates can weigh on bond market performance in the short-term, the higher coupon payments received from a high-quality bond portfolio should result in greater returns over a multi-year period. Finally, as we note in the previous post, we believe that the Fed is much closer to the end of this hiking cycle than the beginning. If that proves true, the upside for interest rates (and downside for high quality bonds) going forward will be more limited than has been the case in the past year.
To be clear, there is a place for cash as part of one’s financial plan, particularly as a ready source of liquidity. As a long-term investment, however, investors should expect to be compensated for the additional risk of holding bonds rather than sitting in cash.
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