Cash Versus Bond Fund: Which Is Better?
The answer depends on what you're trying to accomplish--and the product you choose.
Where's the best parking place for the safe part of your portfolio?
If it's money that you expect to spend within the next year--or even two--the answer is easy: cash all the way. Cash investments are very short-term debt obligations that are often FDIC-insured; CDs, online savings accounts, checking accounts and bank-offered money accounts, and money market mutual funds are all versions of cash instruments. (Of the aforementioned investments, only money market mutual funds aren't FDIC-insured.) The yields on all of these investments are generally quite low relative to bonds; on the other hand, these investments promise stability of principal. If you're saving next year's tuition payment or the property tax bill that's due in October, a cash account is the best place to hold those funds. With such a short spending horizon, not losing money is a bigger goal than eking out a slightly higher return.
But what about funds where you have a slightly longer time horizon--say, two to five years? Here's where the calculus gets a little trickier. Yes, bonds have offered better long-run returns than cash, consistent with the usual return advantage that accrues to investments that entail some potential for loss versus investments that have none. But current cash yields meet--and in some cases exceed--what investors can earn on high-quality bonds today. Meanwhile, bonds entail volatility. That volatility can translate into actual losses for investors who need to shed their holdings after bond prices have declined, whereas cash holdings carry none of that baggage.
To help determine whether cash or a bond fund is the better investment for you, let's examine the major factors one by one.
Long-Term Returns: Advantage Bonds
The long-term returns of bonds are solidly ahead of cash investments. From 1926 through 2017, for example, Treasury bills, a type of cash investment returned 3.4%, whereas U.S. government bonds returned 2-plus percentage points per year more than that. The return differential between cash and bonds has grown even more stark in recent decades, thanks to declining interest rates, which boost bond prices but merely depress cash yields. (In contrast with bonds, which have the potential for appreciation as well as losses over an investor's holding period, the return that cash investors earn consists strictly of yield; there's no appreciation potential.) In the 20-year period from 1998 through 2017, for example, T-bills returned 1.9% and government bonds gained more than 6.7%. Indeed, the past 30 years' worth of declining yields, which boost bonds but depress the returns that cash investors earn, largely explain the long-run return differential between bonds and cash. Given how low bond yields are today, a reprise of that fantastic return stretch for bonds is unlikely.
Inflation Protection: Advantage Bonds
Make no mistake: The returns on all investments are vulnerable to inflation, in that higher prices reduce the purchasing power of the returns you earn. Because of their better returns, bonds also look better than cash investments from the standpoint of outgunning inflation. From 1926 through 2017, inflation ran at 2.9%, meaning that the cash investor earning just 3.5% would be barely in the black on a real-return basis. Over the 20-year period from 1998 through 2017, T-bills (cash) have actually lagged the 2.1% inflation rate by 0.2% per year. The prospect of earning nothing--or less--on an inflation-adjusted basis is a key reason why it makes sense to limit cash holdings to funds needed for near-term expenditures.
Current Yields: Slight Advantage Cash
Bond returns have clearly been better than cash yields in the past. Yet an interesting phenomenon is in play right now. Investors can currently pick up cash investments, such as online savings accounts, with yields that are right in line with, if not better than, what's available on short-term bond funds. For example, Vanguard Short-Term Bond Index (VBIRX) currently has an SEC yield of 1.76%, whereas Vanguard Prime Money Market, a money market fund, has an SEC yield of 2.09%. Even FDIC-insured cash investments, like online savings accounts, are yielding more than 2% today. Of course, not all cash instruments have such lush yields, which is why it pays to not settle for that 0.00001% yield you might be earning in your interest-bearing bank account. But the fact that yields are so similar for investments that are risk-free (cash) and those that bear risk (bonds) is unusual, and burnishes the appeal of cash for short-term investments.
Volatility: Advantage Cash
On the other hand, you probably don't hold cash or bonds to be a return engine for your portfolio; that's what stocks are for. Instead, you own them to protect your principal, first and foremost, with a little bit of income on the side. From the standpoint of limiting volatility--and indeed real losses if you need to tap into your portfolio in one of those weak periods--cash investments trump bonds and bond funds. Cash investments guarantee--or in the case of money market funds, offer an implicit guarantee--of principal stability, whereas bond investments do not. That means that volatility is a nonissue for cash investors (notwithstanding the unlucky investors in the Reserve Primary fund), whereas bond investors may have to put up with a fluctuations in their principal.
Just how much extra volatility depends on what kinds of bonds you own. Short-term bonds tend to experience limited volatility: Between August 1972 and August 2019, for example, the typical short-term bond posted a loss in just 6% of rolling one-year periods, and no losses whatsoever in rolling three-year periods over that stretch. Because they court more interest-rate risk, core intermediate-term bonds have been more volatile, experiencing losses 20% of the time over rolling one-year periods and 5% of the time over rolling three-year periods between the mid-1950s and today. Most of those losses are concentrated in the 1970s, but there's no guarantee that a period of sustained rising rates won't roil bonds at some later date. That suggests that if your time horizon--that is, proximity to spending--is less than three years, intermediate-term bonds are a too-risky choice.
Of course, investing in individual bonds, as opposed to bond funds, can help mitigate some of the risks; assuming you hold the bond to maturity and the issuer is creditworthy, you won't confront losses in periods of interest-rate changes, like the 1970s. However, that approach carries its own risks, the biggest of which is that it can be difficult to build a portfolio of individual bonds that's adequately diversified.
Security Selection Counts
Deciding between cash and bonds requires careful consideration of the trade-offs between yield, return potential, and volatility. But the specific products that you use to populate your exposures can also make a big difference. Cash yields tend to be enormously variable, so it pays to shop around and avoid tying up large sums in accounts that are convenient but yield next to nothing. (Brokerage sweep accounts are a spot where yields are notoriously low.) If you venture into bond funds, be sure to mind the relationship between expenses, yield, and risk-taking. Some funds can achieve competitive yields by maintaining low-risk portfolios and keeping costs way down, while others push through above-average expenses--and yields--by building higher-risk portfolios. Risk hasn't been a big consideration for bond investors in recent years, notwithstanding occasional short, rocky patches like 2018's first quarter, but it could become a bigger deal in a weakening economy and/or rising-rate environment.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.