Should You Hold Cash Instead of Bonds Today?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. With a threat of rising interest rates roiling the bond market, investors may be wondering if they should just hold cash instead of bonds today. Joining me today to discuss the topic is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.

Hi, Christine. Good to see you.

Christine Benz: Hi, Susan. Good to see you, too.

Dziubinski: Before we get into a conversation about cash versus bonds, let's take a step back and maybe talk a little bit about why investors should be bothering with such low-returning asset classes at all today.

Benz: I think it's a really valid question, Susan. And there are a couple of key reasons. One is that by adding even a little bit of safer assets to an aggressive portfolio, you can reduce its risk by quite a lot. And you can do so without really reducing its return potential a lot. So, that is the big takeaway from Harry Markowitz and Modern Portfolio Theory. And then the other sort of more practical reason is that most of us are holding portfolios, building portfolios for some spending goal further out into the future. And the idea is that as we get closer to needing to spend from our portfolios, it does make sense to derisk that portion of our portfolios that we expect to spend within the next five to 10 years. I think it is important, especially for people who are approaching retirement or some other goal date to think about derisking their near-term spending needs by moving some of the money from stocks into cash and bonds.

Dziubinski: Let's talk specifically a little bit about the advantages of cash. Clearly, the biggest advantage is to be able to have the ability to sort of protect your principal and not risk losses. Right?

Benz: That is, and I think it's important, Susan, to note that not all cash instruments are FDIC insured. So money market mutual funds, for example, are a big widely held category, not FDIC insured, not guaranteed. But from a practical standpoint, when we look at the ability of cash and cashlike instruments to hold investors' principal value steady, historically, they've done a really good job. That is the big role of cash investments. If you have money where you can't afford any losses whatsoever, cash is going to be your best option.

Dziubinski: Let's pivot and talk a little bit about the bond market and what's been going on there. It's been a little bit of a rough sledding in the bond market so far this year, and the Fed hasn't even taken any official action yet. What's been going on?

Benz: Right, it's interesting to see how the bond market kind of gets ahead of the Fed action. The Fed has done a great job, in my opinion, of telegraphing its maneuvers, telegraphing when and why it expects to lift interest rates this year. And so the bond market is anticipating those changes, we've seen yields on the 10-year Treasury jump up by 70 basis points just since last summer. So, the bond market is obviously anticipating and pricing in some of these rate changes.

Dziubinski: Christine, what is the advantage then today for investors to be holding bonds at all? Are there drawbacks to just moving into cash and hunkering down there for a while?

Benz: I think the big drawback is that, likely over any period of time, cash returns will be lower than bonds'. We think of starting yields as being a good predictor of what you're apt to earn from an asset class over the next decade. Yields on cash instruments are in the neighborhood of like 0.5% today. Now we're at the point where intermediate term bonds are yielding closer to 2.0% today. I think that there is going to be a return differential for people who have reasonably long holding periods; the big disadvantage of holding cash is that you're kind of locking yourself into a fairly low yield.

Dziubinski: Christine, what role does inflation play in making this decision?

Benz: It's a good question, Susan. And the short answer is that inflation is bad for all asset classes that have a fixed interest rate attached to them, because over time, inflation is going to eat away at the purchasing power of those fixed-rate investments. But inflation will tend to take a bigger bite out of cash yields because cash yields are lower to begin with. That's the big caution against having too much of a portfolio stashed in cash investments--the return potential is very low, and we've seen inflation flaring up a little bit recently. And so it's a bigger risk factor.

Dziubinski: Does the fact that we've seen stocks and bonds move a little bit more, let's say, in sync recently sort of undermine that argument that bonds can provide ballast to an equity-heavy portfolio?

Benz: I think it's an important question, Susan. And the short answer is that we're not sure. We haven't had that many periods in modern market history where we have seen interest rates moving up. And so what we have seen recently is that we've seen bonds and stocks move a little bit closer together, where in fact, they're both responding to the fact that interest rates are going to be going up. So, I think it's an open question. I think it's something that investors should keep an eye on. In our most recent looks at diversification and the correlations among various asset classes, we've actually seen that the return benefit that you get, the diversification benefit that you get, from intermediate-term and long-term Treasury bonds has been a little less very recently than it has been in the past. Whereas cash has been conferring a little bit more of a diversification benefit. So, watch that space. I would say that's one reason why for investors who do have safe investments in their portfolio that they probably want to have a combination of cash as well as bonds in their portfolios.

Dziubinski: Christine, how should investors approach the question then, of when to hold cash and when to hold bonds?

Benz: You probably won't be surprised that I'll say that it really depends on your time horizon, your proximity to spending your money. So the way I think about it is kind of this bucketing framework where if you have money that you expect to spend within the next one to two years, you'd want to keep that completely derisked, hold it in cash, don't worry so much about inflation, because it's probably not a large percentage of your portfolio. And then for money that you expect to spend in the next, say, three to eight or three to 10 years, you might hold that in bonds, where you're likely to pick up a little bit higher return, a higher yield, you may do a better job of keeping pace with inflation with that portion of your portfolio, and then any money for the years beyond that for expenditures in those years. I think you can reasonably hold stocks, but I would use that time horizon to inform how much I allocate to both cash and bonds.

Dziubinski: Well, Christine, thanks for your time today, particularly maneuvering the bonds versus cash question in these kinds of tricky markets. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.