Cash and Money Market Funds vs. Bonds: Which is Better?


Bond Concepts by Madison Investments

Second Quarter, 2023

As the Federal Reserve (Fed) orchestrated a historic increase in interest rates to combat inflation, fixed income investors finally saw income return to their portfolios. The 10-year Treasury bond, which yielded 0.6% in August 2020 had surpassed 4% by October 2022. As interest rates rise, bond prices fall, and the rapid rise in interest rates brought with it significant portfolio revaluations. The 0.6% yield proved insufficient in buffering the rate increase, and many investors saw double-digit negative returns in 2022. But with the Fed indicating its tightening cycle may be nearing an end, we believe much, if not all, of that negative performance is behind us.

Many investors, as indicated by the Fed Funds futures markets, believe the next move in rates will be down, possibly by the end of this year. With the potential for an economic slowdown and uncertainty in markets, the essentially risk-free asset of cash is tempting many investors with yields that have not been available in 15+ years. Some may be questioning the role of fixed income when cash can yield the same amount or more.

Having experienced the impact of interest rates rising, let’s examine what investors may face if rates move in the other direction. Understanding this phenomenon is essential when deciding whether to invest in cash or bonds. Let’s start with the basics.

The basics: Money Market and Bond Funds

Cash–including money market funds, high-yield savings accounts, and short CDs–and bonds are all perceived to be relatively “safe” investments, but differ in terms of their risk level and return potential. Cash is the least risky of the three but offers the lowest potential return. Money market funds are a type of mutual fund that invests in short-term, low-risk securities such as treasury bills and commercial paper and offer a slightly higher return than cash. Bond funds invest in various fixed-income securities with varying maturities and credit ratings and offer a higher potential return than money market funds but also come with greater risk.

Short-term bond funds typically invest in bonds with maturities of five years or less. Intermediate bond funds invest in bonds with maturities out to ten years, while long-term bond funds can invest in bonds with maturities of thirty years or more. Longer-term bonds are more sensitive to interest rate movements than short-term bonds. Interest rate risk is measured by a bond’s duration.

Duration

Duration is a measure of the expected change in a bond’s price for a given change in yields. When interest rates rise, duration becomes a tangible measure of a bond’s decrease in value. However, duration also offers the potential for capital appreciation. When interest rates fall, the price of a bond increases, leading to capital gains for investors should they decide to sell the bond before maturity. The greater the duration, the greater the price appreciation (falling rates) or depreciation (rising rates). If an investor anticipates interest rates will fall, having exposure to longer-duration securities like bonds can provide a bump for the return of a portfolio. With cash and money market funds, if interest rates fall, there is little opportunity for price appreciation.

Income +/- Change in Price = Total Return

The total return on a bond or portfolio of bonds is a function of the income it generates plus or minus any change in price. For most bonds, the level of income a bond will provide is set when it is bought. It is simply the coupon adjusted for the price paid for the bond. Change in price is a function of the duration of a bond (described above) and the amount of change in the bond’s Yield to Maturity (YTM). The total return potential in today’s market is far more appealing for bond investors than just a short time ago when interest rates were low and credit spreads were tight. It is quite common for a high quality, intermediate bond portfolio to offer a starting YTM well over 4% today versus under 1% just a few years ago.

As the illustration below shows, the current, higher yield environment adds value whether rates rise or fall. If rates rise, the higher level of income acts as a cushion, offsetting some of the expected price decline. If rates fall, having some duration in a portfolio provides a meaningful upside. An investor not only enjoys the higher level of income available today but also the potential capital appreciation that produces attractive total returns in a falling rate environment.


Returns in Rising and Falling Scenarios Chart web

Why CDs and Money Market Funds may not be the right investment today

Reinvestment Risk

Another important consideration related to the movement in interest rates is the yield at which the proceeds from an investment are reinvested. Interest and principal payments are reinvested at whatever going rate the market dictates when they are received, not at a constant rate. As rates fall, maturing bonds with higher yields are replaced with lower-yielding bonds, reducing income. Conversely, as rates rise, a portfolio’s income rises as low-yielding bonds are replaced with higher-yielding ones. Reinvestment risk is a function of interest rate volatility and the maturity structure of the underlying investment.

With longer-term bonds, in return for taking on the interest rate risk (duration), investors are exposed to less reinvestment risk. With cash or other short-term investments, an investor takes very little interest rate risk but is exposed to extreme reinvestment risk. For example, investor A invests in a money market account yielding 4%, and investor B invests in a five-year bond yielding 4%. After one year, if interest rates decline and the money market account is now yielding 2%, investor A will earn a lower yield. Alternatively, investor B will still earn 4%, as the bond was locked into that rate for five years. In addition, assuming the five-year yield also fell, the investor would enjoy appreciation of the underlying bond. Remember, in a falling rate environment, Total Return = Income + Capital Appreciation.

Of course, rates could also rise from here, and the locked-in 4% bond yield for investor B would become a lower yield than cash. But if the Fed is to be believed and the market’s expectations are correct, the most likely path for rates over the next 12-24 months is lower. While cash or an equivalent investment may provide an attractive yield today, that yield, and therefore the income generated, may evaporate with little to no potential for capital appreciation as rates normalize. A portfolio of intermediate bonds, on the other hand, will maintain most of its income-generating ability while also providing attractive total returns as holdings in the portfolio appreciate.

Both cash and fixed income can play important roles in a portfolio. For some investors, locking in a longer-term cash flow may be important; for others, capital stability may be important. While bonds offer the opportunity for both a fixed income and capital appreciation, cash and money market accounts offer relative safety. The type of investment that is right for you will depend on your investment goals, risk tolerance, and current market conditions.

Why outlook is important

The outlook for interest rates is critical when allocating an investment portfolio, especially when cash and longer-term bonds offer similar yields. Cash can be an important tool when navigating periods of rising interest rates, but only after considering reinvestment risk and the potential opportunity cost of capital appreciation should rates fall. An active fixed income manager can implement views on interest rates, the market, and the economy when constructing a bond portfolio. Decisions such as yield curve positioning, credit quality, and duration exposure can work to reduce risk and take advantage of developments in interest rates.


BOND CONCEPTS BY MADISON INVESTMENTS

Learn the nuances of fixed income investing, including the risks, opportunities, and investment styles.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

The charts and graphs in this material are mathematical examples only and do not represent and Madison strategy. The assume bonds are held to maturity and experience no default, call or other credit event.

Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting the yield of one instrument from another.

In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

Principal preservation statements relate to investment objectives and assume all bonds are held to maturity with no defaults. Market value between purchase and maturity may vary.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

Yield to Maturity (YTM) measures the annual return an investor would receive if they held a particular bond until maturity as of the end of a report period In order to make comparisons between instruments with different payment frequencies, a standard yield calculation basis is assumed This yield is calculated assuming semiannual compounding.

Diversification does not assure a profit or protect against loss in a declining market.