Now that interest rates are higher, you may be wondering whether it makes sense to invest in a bond fund when you can earn a relatively high rate of return on cash through money market, CDs, treasuries, or a savings account.
These feelings are especially understandable after 2022, a rare year in which stocks and bonds lost money at the same time. History shows that most of the time, bonds can help shelter your portfolio against stock downturns.
We recommend the decision on cash vs. bonds be made based on how soon the money will be used.
For funds to be used in the next couple of years, it should absolutely be in cash. Now that interest rates have increased, you can receive in the 4% – 5% range with little/no risk to principal.
For longer term goals like retirement or saving for your young child’s college education, bond funds still make the most sense. In most time periods, bond funds will provide significantly higher interest rates than cash. When we build long-term models to help you plan for the future, we are planning on the higher returns of bond funds.
It’s also important to note that bond funds provide more diversification than cash from stock market performance in most economic conditions. When the stock market falls for reasons other than inflation and interest rate increases, we often see bond funds jump in value while stock funds are falling. This bump in principal value of your bonds helps offset the losses in stocks. There is no corresponding jump in the value of your cash holdings, so you get less diversification benefit.
Can you time the market?
While it can be tempting to think that you can enjoy cash now and then quickly switch to bond funds as their yields diverge, it’s unlikely that you’ll be able to make the switch at exactly the right time. While we know when the fed will meet and often have an excellent sense of actions they are likely to take, market adjustments of rates typically happen at different times and can even be in opposite directions, as we saw in this spring’s banking crisis. We’ve all heard that attempting to time the market is not an effective strategy, and it’s no different in this situation. If you’re sitting in cash while bond funds are earning a lot more, you’ll have realized a hard opportunity cost that can jeopardize the success of your long-term plan.
Another downside of cash for longer term goals is reinvestment risk. Shorter term instruments that require constant reinvestment are quickly subject to drops in yield when rates fall. Vanguard provides a more in-depth analysis of the cash vs. bonds issue in the attached paper if you want to explore this issue further.
We build financial plans fully expecting interest rates to rise and fall over time. Years like last year are factored into the model. For long-term investors, tolerating drops in their bond fund values is a necessary cost to benefit from the long-term benefits to your portfolio and financial plan they can provide.