I’d Be Better Off in Cash!

By Michael Lieberman, Partner

As investors have accepted the interest rate “higher for longer” narrative, there are large a number of financial advisors having to defend the purchase of bonds in their client accounts.  After all, as yields across the spectrum have moved higher, bonds prices have moved lower.  Frustrated clients imply they would have been better off in cash and advisors are left scrambling.  However, the better off in cash argument only works if you ignore some really important details.
Let me explain:

1. Inflation got the Federal Reserve to raise interest rates and as we all know that when rates go up, bonds go down. We see this value fluctuate as investors are buying and selling, creating all sorts of real time trade activity. Cash on the other hand doesn’t trade. There are no prints. One dollar will always be worth one dollar. But what happen when a dollar doesn’t go as far as it used to? Isn’t that also value lost? In fact, from January 1, 2020 through September 1, 2023, the purchasing power of the US dollar is -16.20%.

Let’s look at the math on a longer time frame. The year is 1970 and you have $3,000 to your name and a choice to make. Buy a new car or put your money
in the bank. If you chose to bank and collected 3% interest per year, the funds would be worth approximately $7,383.04 at the end of 2022. The cost of the car, on the other hand, went from $3,000 to $40,000. So, now you can afford nice tires, but no car.

2. When you buy an individual bond, you have the comfort of knowing it will mature at par, unless they default. And therefore, you can calculate the yield-to-maturity (YTM) to the tenth degree. It is worth mentioning that YTM doesn’t play out in a straight line. Again, that day-to-day trade activity pushes prices higher and lower. But if held to maturity, your YTM will average out on an annual basis to the same number that was calculated at purchase. So, in the time frame of purchase until maturity, it should not matter what the bond price does. Maturity at par should bring an investor a return greater than cash.

Let’s look at the math in an example bond purchase.  You buy a bond at 100 (par) with exactly two years until maturity and a 5% coupon. Your expectation is to collect 10% in interest over the course of two years, 5% each year. But as a result of some Federal Reserve actions, at the end of year one, your bond is now trading at 95. The return thus far is a whopping zero, since the coupon was
offset by the price decline. But the bond is a solid credit and default is not an issue. In year two, this bond will work its way higher and will mature at 100, along with paying you the annual 5% interest. Your average annual return was still 5%, even though it all came in year two.  

3. Investors always need to consider reinvestment risk – meaning will there still be attractive yields when cash investments or money funds are no longer attractive?
After all, owning cash now is essentially making a bet after the Fed may have accomplished its goal of bringing inflation down. History shows that yields on cash could fall rather quickly. Since  1973, there were eight instances when cash yields dropped by at least 4%;

WELL, I’D BE BETTER OFF IN CDs
Once cash has been recognized as an asset that can lose value, at least in real terms, the conversation inevitably turns to bank CDs. Why not just get 5% from the bank and not have to deal with the fluctuations and anxiety of the bond market? Again, details here cannot be ignored. CD’s don’t typically have an exchange that values them on a day-to-day basis – the idea is that they are held to maturity. However, if they did have a pricing exchange or an investor needed to liquidate before maturity, the value would not be spared from the fluctuation provided by a rising interest rate
environment. If an investor is willing to ignore that noise because the asset does not frequently trade, they should be willing to do the same to collect potentially a higher yield from a portfolio of individual bonds. But like everything on Wall Street, nothing is free. The cost for that higher yield is the non-linear march to maturity 

As an alternative, if you chose to invest in an individual bond portfolio with a 4 year duration, as of November 2023, you will earn a yield to maturity of roughly 6.25%*. Should rates fall, you have locked in that higher yield for a few more years, while cash will provide significantly less.

*Current gross yields/investment grade corporate bonds/ACM Fixed Income through Monday, 10/30/23. Subject to market conditions and yields can change at anytime.

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