Vanguard Commentary: Why Bonds- and Not Cash- Endure in Retirement Plans
Not even plan sponsors and consultants have been immune to the great “cash versus bonds” debate over the last two years. The persistence of higher interest rates has left stewards of employer-sponsored retirement plans wondering if they should adjust their investment lineups. Such concerns are natural even though Vanguard has seen a decrease in cash positions within defined contribution plans and a decline in plan participants allocating contributions to cash since 2014.1
The surge in inflation to generational highs because of pandemic-related distortions led the Federal Reserve to pursue an aggressive interest rate policy starting in March 2022. The federal funds rate rose from near-zero levels to its current target range of 5.25% to 5.50%. Stronger-than-expected economic data during the first half of 2024 has led to uncertainty around the timing of eventual Fed rate cuts. When cuts do begin, Vanguard expects interest rates to settle higher than they were following the 2008 global financial crisis or during the COVID-19 pandemic.
This backdrop has been a tailwind for cash and other short-term investmentswith yields north of 5% as of mid-2024and has attracted a lot of investor interest. In hindsight, an overweight to cash since the onset of interest rate hikes has paid off for many investors given cash’s lower interest rate sensitivity compared with longer-duration bonds. Vanguard Cash Reserves Federal Money Market Fund, for example, has returned more than 9% cumulatively from mid-March 2022 through June 2024, while Vanguard Total Bond Market Index Fund, a measure of the broad U.S. bond market, lost more than 3% during the same period. While cash outperformed bonds over the last couple of years, it’s important to understand why this is highly unlikely to continue over the long term.
Investment decisions have trade-offs. Those who invest in cash have a primary goal of preserving principal. Cash or cash equivalents are readily available short-term financial instruments that are highly liquid, have minimal or negligible market risk, and have a maturity within 90 days.2 When investors choose to invest in cash, they will generally maintain their principal while earning interest income with low return volatility. The trade-offs, however, can include reinvestment risk, lower long-term returns, low to negative real returns because of the effects of inflation, and reduced portfolio diversification when needed most.
Normally, bonds with longer maturities require higher yields to compensate investors for additional risks. Occasionally, there are periods when this relationship doesn’t hold, as we see today, and investors can earn more income in cash and short-dated bonds than in longer-dated bonds. We do not believe that trend is sustainable.
As of June 30, 2024, 1-month U.S. Treasury bills were yielding 5.5%, while 10-year U.S. Treasury bonds were yielding 4.4%.3 This can be an attractive proposition for many investors, but remember that different maturity profiles can result in differing long-term return expectations. In the case of the 10-year bond, investors would be receiving a yield of 4.4% per year for the next 10 years if that bond were held to maturity. In the case of the 1-month Treasury bill, investors would receive an annualized rate of return of 5.5% for the next one month. When the original principal is received one month later, at maturity, the market rate for reinvestment is unknown, as yields could be higher or lower. Therefore, reinvestment risk may be associated with the one-month investment compared with the 10-year investment over the next decade. The risk is that if yields were to fall, the investor would begin to earn a yield lower than what they could have earned by investing in the 10-year bond. While longer-dated bonds generally have more yield durability, all investors should consider their time horizon when making investment decisions.
Longer-dated bonds typically provide higher income, a key driver of their superior long-term returns compared with cash, as most of a bond investor’s total return comes from earned income. During the last 30 years, the average annual return of the broad U.S. bond market has been 4.4%more than double the return of cash. Furthermore, the Consumer Price Index, a measure of broad-based inflation, averaged 2.5% over the same time. Although cash and bond investors would have seen their balances increase, investors in cash lost purchasing power, or wealth, in real terms, as inflation grew at a higher annualized rate relative to cash.
In this box and whisker chart, using Vanguard’s proprietary forecasting model, the Vanguard Capital Markets Model (VCMM), we show that bonds are expected to continue outperforming cash over the long term. Even though our model forecasts a positive inflation-adjusted return for cash over the next 30 years, its limited ability to keep up with inflation considerably erodes purchasing power.
Projected 30-year returns for equities, bonds and cash
Portfolio efficiency trade-offs can also occur when asset classes are added or removed from an investor’s allocation. An allocation to cash, for example, safeguards that portion of the portfolio from market risk, but it may not pair as well with other asset classesespecially equities. While cash helps with preserving principal, it lacks duration. Although this can be beneficial when interest rates are rising, the buffering effects of cash fade when interest rates are falling. Cash has a high, positive correlation to changes in the federal funds rate. When the economy begins to slow and equity markets sell off, there is generally a reduction in the federal funds rate to help spur economic growth. As this rate falls, cash yields fall, but bond prices rise, helping to offset unrealized equity losses. Since 1994, in periods when U.S. equities had a negative 12-month return, the median annual return of bonds was about 7.6%, versus 1.4% for cash. As shown in this bar chart, when considered in the context of a balanced total portfolio and despite their own risks, bonds have historically done a better job buffering against equity losses in down markets.
Bonds tend to provide better downside protection against equity losses
It’s understandable that high-yielding money market funds might tempt some investors to hold more cash and less in bonds until the Fed begins cutting interest rates. However, bonds historically have outperformed cash over short, intermediate, and longer-term time horizons following the peak of Fed tightening cycles. The line chart shows the cumulative growth of cash and bonds following a period of aggressive Fed monetary policy during 1999 and 2000, in response to the dot-com bubble. From the date of the Fed’s final rate hike on May 16, 2000, bonds returned a cumulative 87.9%, versus 34.4% for cash over a 10-year period.
Cumulative growth of bonds and cash over 10 years following the peak of a Fed rate-tightening cycle
We expand the analysis in the table that follows to include three other rate-tightening cycles that occurred within the past 30 years. We show the annualized total returns for cash and bonds for the 1-, 3-, 5-, and 10-year periods following the Fed’s final rate hike during each respective cycle. Except for the 5-year period that ended on December 20, 2023, (which includes the recent 20222023 rate increases), bonds have outperformed cash by a comfortable margin. While past performance doesn’t guarantee future resultsand this cycle could be differentwe believe bonds are superior to cash for meeting most investors’ long-term goals.
Bonds have mostly outperformed cash following the end of multiple Fed tightening cycles since 1995
When will the Fed start cutting interest rates? That’s hard to predict, and the decision is not something investors can control. Plan sponsors focused on the financial well-being of their participants should approach the “cash versus bonds” debate objectively.
Cash can be a tool for managing liquidity risk, such as meeting day-to-day needs and saving for emergencies. A strategic allocation to cash may also make sense for some investors with short-term goals and low risk tolerance. However, even in today’s high-yielding environment, cash investments should not be viewed as a substitute for stocks or bonds. Additionally, overweighting cash and trying to time reentry into bonds can come at the cost of long-term underperformance and the risk of falling short of one’s financial goals.
The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at www.vanguard.com/performance. The yield quotation more closely reflects the current earnings of the fund than the total return quotation.
1 Plan assets invested in cash were 6% in 2023 compared with 11% in 2014, according to Vanguard’s How America Saves 2024 report. Plan participants had 3% of their average account balance allocated to cash in 2023 compared with 8% in 2014.
2 Vanguard research paper. A Framework for Allocating to Cash: Risk, Horizon, and Funding LevelOpens in a new tab, April 2024, p. 2.
3 U.S. Department of the Treasury, using data as of June 28, 2024, for daily Treasury par yield curve rates, referred to as “Constant Maturity Treasury” rates.
This article first appeared on GuruFocus.