UNDERSTANDING THE PROS AND CONS
“Why should I be investing in bonds when I can earn more than 5% on my cash?” Many investors are asking this question, after being discouraged by losses they have experienced with bonds in recent years.
The question is reasonable, particularly since bonds are intended to limit the downside when stocks sell off. Unfortunately, bonds have recently failed to provide that protection, as these facts confirm:
- From the start of 2022 through the third quarter of 2023 the Bloomberg U.S. Aggregate Bond Index lost more than 14%.
- Longer-term bonds have fared significantly worse. The iShares 20-Year Treasury ETF (TLT) lost nearly 30% over that same period.
- In late October 2023, the TLT had dropped 44% from its high roughly three years prior.
An ETF investing in Treasury bonds (none of which defaulted) lost more than 40% of its value! If we knew for certain the next three years were going to look like the last three, investors would not want to double down on bonds. However, a repeat of the prior three years is highly unlikely.
Before providing an outlook on the bond market or comparing the potential benefits of investing in bonds, it may be helpful to understand the factors influencing bond pricing and why bonds experienced losses in 2022 and 2023.
What factors influence bond prices?
While the complete academic answer is a bit complicated, for practical purposes an investor needs to understand the two key factors: credit quality and duration.
- Credit quality reflects the likelihood that a bond will default. The recent decline in bond prices had little to do with credit quality. Consequently, we will not spend time on this topic, other than to say there is an implied belief that U.S. Treasury Bonds will not default.
- Duration is a term used to reference a bond’s sensitivity to the movements of interest rates. A simple way to think about this term is that it reflects how long it takes for your initial investment to be returned.
If you purchase a five-year bond, your principal will be returned in five years. (The average maturity of a bond fund is often confused with duration). You are likely to receive interest payments every 3-6 months, therefore a portion of your money is returned to you before the end of the five-year period. The higher the interest rate, the sooner your principal is returned to you. A 5% bond will return your money faster than a 2% bond. Consequently, the 5% bond has a lower duration and is less sensitive to interest rate movements in comparison to the 2% bond.
Case Study: What Happened to Bond Prices?
Consider an investor purchasing Bond A, a 5-year Treasury Bond for a 2% yield in January of 2022 when cash was essentially yielding 0%. One year later, after interest rates skyrocketed, an investor can purchase Bond B, a 4-year Treasury yielding 5% (yields have been rounded up for simplicity and do not reflect actual yields).
We now have two bonds maturing in 48 months. Let’s assume a $100,000 investment.
- Bond A will pay $2,000 per year and $8,000 over four years.
- Bond B will pay $5,000 per year and $20,000 over four years.
Bond B is now worth $12,000 more than Bond A, therefore Bond A will need to be repriced accordingly in the public markets. Investors in Bond A will have a significant paper loss in the calendar year, however, owners of both Bond A and Bond B will receive their initial $100,000 investment in 48 months.
The following year each bond has three years of interest payments remaining and Bond B will pay $9,000 more in interest than Bond A over the remaining life of the bond. Naturally, the difference in value between the two bonds has changed. Bond A will increase in value to reflect the difference in future cash flows, which have decreased from $12,000 to $9,000. The investor in Bond A has received $2,000 of interest and a $3,000 paper gain. As the two bonds approach maturity, the price disparity continues to shrink. The investor in Bond A has recovered all their paper losses. Of course, the downside is they received less interest over the last 48 months than the investor in Bond B.
Answering the Question: Bonds vs. Cash?
Cash is technically not an actual investment, but investors can hold cash equivalents, such as CDs, Treasury Bills, or money market funds. For the purposes of this discussion, we focus on money market funds to differentiate cash equivalents and bonds.
Advantages of Owning Money Market Funds
- The interest rate is variable, and money market funds are required to purchase securities with a very short maturity. Therefore, if the Fed increases interest rates, your money market fund yield will move higher.
- Prices will not fluctuate (assuming proper risk management is in place). These funds are committed to maintaining a $1 per share price. Instances of money market funds falling below the $1 per share price are extremely rare.
- Money market funds offer immediate liquidity; Investors can generally access their cash in in a matter of days.
Disadvantages of Owning Money Market Funds
- A variable interest rate is a disadvantage when rates are falling. Money market funds own securities that are maturing every week, therefore yields will quickly move lower in a falling rate environment.
- Yields are typically lower than bonds. There is an expense in buying and selling securities, which means money market funds are likely to have a management fee.
Advantages of Owning Bonds
- Bond (and bond fund) yields are typically higher than money market funds. While the spread between bonds and money market funds is narrower today than it has been historically, investors are receiving more income from bonds.
- Bonds will appreciate if interest rates fall. Although bonds have experienced price losses over the recent three-year period of rising interest rates, the opposite will transpire in a falling rate environment.
- Individual bonds allow investors to lock in a yield, which is advantageous if you believe the economy will slow and rates are likely to decline. Bond fund yields are variable; however, their yield will decline more slowly than money market funds.
Disadvantages of Owning Bonds
- Bond prices fluctuate negatively in a rising rate environment. Investors know this very well after unprecedented increases in interest rates in 2022 and 2023.
- Investors in bonds face the potential of owning a vehicle that pays below market rates for years. Even if holding the bond until maturity will ensure a return of principal and offset paper losses, the opportunity cost for the investor is the lost cash flow.
- Bonds have a higher risk of default than money market funds. While this may not be the case with Treasuries, there is always a chance a business or municipality declares bankruptcy and is not able to pay its debt.
Bonds and money market funds play an important role in nearly every investor’s portfolio. Money market funds will generally outperform bonds in a rising interest rate environment. If interest rates are falling or unchanged, an investor will generally experience better performance from owning bonds.
While the phrase “cash is king” becomes popular when financial assets are selling off, the data tells us otherwise. Bond returns have consistently exceeded the returns of cash and cash equivalents. From 2008-2022, bonds outperformed cash by a 2.1% annual average. While 2022 was the worst-performing year in the modern history of the bond market, the year’s results failed to offset the outperformance of the preceding 15 years. Longer-term returns tell a similar story.
Today’s frustration with the bond market is certainly understandable. While the instinct of most investors is to sell an asset when it has performed poorly, a key to successful investing is to remove the bias of past performance when assessing the outlook for an investment. An experienced financial advisor can help you allocate assets within a diversified portfolio that is designed to withstand volatility and build wealth to reach your long-term financial goals.