If “cash is king,” is there a case for maintaining a core fixed income allocation today?

The sharp uptick in yields on cash-like investments, including money market funds, and short-term bonds has been a welcome development for those needing to maintain some allocation to highly liquid, safe assets. That being said, long-term fixed income investors should keep a few key considerations in mind.

Elevated short-term yields are a direct byproduct of the Federal Reserve’s aggressive rate hiking cycle. Long-term yields have also risen since 2020, but to a much lesser degree, creating an inverted yield curve in which short-term rates exceed those of longer-term bonds. Such conditions are temporary; the yield curve will in time revert to its normal upward slope. Consequently, tilting toward cash within a fixed income portfolio introduces “reinvestment risk” — the risk that yields decline and investors are forced to reinvest maturing bonds in lower-yielding securities.

For cash, the impact of falling yields is immediate. Long-term bonds, however, don’t have the same degree of reinvestment risk due to their longer maturities, allowing them to continue to provide a predictable level of income even as interest rates fall. Additionally, long-term bond prices may be somewhat resistant to fluctuations in short-term interest rates but will still benefit from declining rates via price appreciation. As illustrated above, core bonds have historically outperformed cash by a significant margin outside of rate hiking cycles, with cumulative outperformance averaging 30% during the period between the Fed’s final hike in one tightening cycle and its first increase in the next hiking cycle.

The bottom line? Yields matter, but simply chasing the highest yield typically hasn’t provided the best overall return when short-term rates are stable or declining. Core bonds have typically outperformed cash at that stage in prior cycles, justifying a dedicated allocation in a diversified portfolio for long-term fixed income investors.