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Tuesday, July 13, 2010

Cash and Bonds are Different

Cash and bonds are different. Cash is generally any fixed income instrument that matures within one year. This includes certificates of deposit, money market funds, savings accounts, and even bonds maturing within one year (for example, a 5-year maturity that was issued 4 years ago). Bonds, on the other hand, are fixed income instruments that mature out past one year and whose price varies with interest rates. As interest rates rise, bond prices decline and vice versa. The bottom line is that the returns for bonds (also classified as fixed income) and cash are different, and this difference should be kept in mind in the asset allocation process.

Sector Returns
To appreciate the difference in performance between cash and fixed income, consider the 20-year period presented by BlackRock: CLICK IMAGE TO ENLARGE

The table shows that the return on fixed income as an asset class varied between +18.5% (1995) and -2.9% (1994). Cash returns varied between +8.4% (1990) and +0.2% (2009). The 2009 cash return, of course, reflects the fact that, today, short-term interest rates are at the lowest level in 20 years.

The fixed income sector in the table represents the overall investment grade bond market as represented by Barclay's Capital U.S. Aggregate Index. It essentially encompasses the U.S. investment grade bond market for issues having a maturity greater than 1 year.

In looking at the fixed income returns in the table, it is notable that there were 4 years out of the 20 where returns were double-digit positive. In these years, bond prices rose as interest rates dropped. The capital gain along with the year's interest produced double-digit gains.

Flip this around, and notice that there were only 2 years where returns were negative. In these years, bond prices dropped because of rising interest rates and overcame the positive contribution from the interest payment. Still, as noted above, the biggest negative return was only -2.9% in 1994.

The negative returns beg the question of what would it take to get a big negative drop? Another way to ask this is: should we be worried about the much bally-hooed bond market bubble. In fact, conditions are ripe for a decent sized downturn - yields are low and could rise a sizable amount over a fairly short period of time because of macroeconomic conditions involving the Federal Reserve flooding the banking system with reserves and a fiscal policy mess at the Federal and State levels.

Follow Up
Read up on 1994 to understand the conditions that produced the -2.9% in the fixed income sector. Also look up the the 12-month returns for HYG, TBT, and CSJ to see how widely varying the returns are within the fixed income sector. Finally, pull out your 401 (k)s and other account statements to review your asset allocation.

Disclaimer: Information is for instructional purposes and is not to be construed as advice specific to any investor.


  1. "Another way to ask this is: should we be worried about the much bally-hooed bond market bubble."

    It will be interesting to see what happens here.

  2. Thanks for the distinction and the admonishment. Are you suggesting that even if there is a bond bubble, it's not a big deal (bonds are relatively stable)? It sounds like you are suggesting that the present conditions are ripe for the much talked about bubble; is this correct?


  3. Shawn-
    Thanks for the questions. I'm going to write another post about this soon because I wasn't real clear. Sometimes clients think they are carrying out an allocation that specifies 30% fixed income by investing in certificates of deposit. But certificates of deposit are cash as far as asset types are concerned - their price doesn't change as interest rates change!
    On the second question I am saying tht conditions are ripe for a bond market bubble. It would be a big deal if interest rates move up a lot especially for investors holding longer maturity bonds.
    Thanks for stopping by.

  4. Good post!

    Hey Robert - in trying to understand your position and perspectives on the emerging bond bubble, does this mean you're not a fan of any bonds, or just long-term bonds?

    Also, what are you thoughts on the classical 60:40 equity:bond split to survive market downturns or eras of high(er) interest rates?

  5. Great questions Financial Cents. I like short-term bonds at this point (CSJ for example) and I even use some high yield (BND). For a 40% bond allocation I would have no more than 20% in overall bond market (BND or AGG). A bubble can take a long time to burst - recall the late '90s stock market.

    I think 60:40 is fine and would even go more aggressively in equities if you are at least 15 years from retirement. But bottom line you do need to sleep at night!