Cash & Short Bonds are Attractive Again

Disclaimer: The article below discusses certain investment strategies, some of which I am using currently in my personal portfolio and some of which I am not. Do your own due diligence before making an investment decision. It’s your money; you’re the best person to judge what is best to do with it.

Ever since the end of the Global Financial Crisis (GFC), many investors and savers resigned themselves to earning next to nothing on their money market or savings accounts.  As the economy has continued to grow and the Federal Reserve has continued to raise interest rates, that’s finally starting to change.  As opposed to just parking cash as a placeholder earning a zero nominal return and losing money after inflation, money markets, US T-bills, and short duration bonds are actually earning a positive absolute return and are nearly keeping up with inflation.  Suddenly, the option value of holding cash does not appear so costly.

The main reason that we’ve seen interest rates rising is that the Federal Reserve is finally reversing course from the actions taken during the GFC.  The Fed Funds rate has been increased seven times in the past three years from 0.25% (reached in December 2008) to a target of nearly 2% today (as of July 2018).  Further, the Federal Reserve has also begun to sell off the massive amount of bonds that were purchased during the GFC (Treasury bonds and mortgage bonds), which also has an impact of raising interest rates.  Now, investors can earn anywhere from 1.5% in money market accounts to over 2.5% for 2-year US Treasury Bonds or high quality investment grade corporate bonds.

Given that cash is finally a real investment alternative, let’s revisit some of the reasons to hold cash.

  1. Option Value: Yes, cash has quite a bit of option value, as we’ve discussed before.  Cash and short bonds provide downside protection (and in fact have nearly none) and allow you to profit from market volatility and big drawdowns.  That combination pretty much sums up owning a put option.  Imagine the difference between having a couple hundred thousand in cash going into Q4 of 2008 versus needing to sell something to take advantage of new opportunities.  Of course the flip side is also true, in that being in cash over the last five years has been painful as markets have continued to rally.  Hence, options do not always pay off.  However, cash and short bonds also provide a fortress balance sheet that’s valuable regardless of the broader market returns.

US Trust, the high net worth office of Bank of America, just published their annual insights into wealthy families.  This study provides a peek into the asset allocation of extremely wealthy families.  The “average” high net worth family has 15% of their asset allocation in cash, which is actually down a bit from previous years.  They also have an average of 21% in bonds, with the rest in the stock market and alternative private investments.  Many “financial professionals” were shocked at how much cash these wealthy people held.  After all, when you have a $10 million portfolio, why do you need $1.5 million in cash?  Yet it’s another case of severe misunderstanding of goals.  There’s a big difference between getting rich and staying rich.   These people are looking to stay rich, which means having a fortress balance sheet, and they’re looking to add to their wealth opportunistically, which means being greedy when others are fearful.  Cash and bonds allow you to do both.

  1. Positive Returns: Cash and bond yields are finally beginning to tick up, especially on the short end of the yield curve. As mentioned above, most of this is driven by Federal Reserve policy, as the short end of the yield curve is always dominated by Federal Reserve policy.  Beginning in 2008 during the GFC, the Fed took some pretty extreme steps to help avert a worst case scenario.  Beyond just decreasing the Fed Funds rate (the rate that banks and the Fed lend money to one another) to near zero, the Fed also purchased an incredible amount of bonds in the open market to help decrease interest rates along the yield curve.  Their purchases pushed up the price of bonds and decreased interest rates since bonds and bond yields move in opposite directions.  The Fed’s balance sheet grew from $800 million in 2008 to a peak of $4.5 trillion in 2015.  Now, the Fed is reversing that policy, both by increasing the Fed Funds rate (now nearly 2%) and reducing the size of the balance sheet (down to $4.2 trillion but the decline is accelerating).

All of these actions have pushed yields higher.  For 3-month Treasury bills and 2-year Treasury notes, yields are at their highest since pre-GFC.

You are also beginning to see corporate credit beginning to increase, with the Barclays 1-3yr Investment Grade Credit yield ticking up.  This should come as no surprise as many investors require a return at least equal to Treasuries plus some spread for credit risk.

Unfortunately, inflation has been picking up at the same time.  This means that although better, the after-inflation yield (real yield) still sits near zero.  Except for a brief period in 2014 and early 2015 when inflation went to zero and even negative year over year, real rates have been consistently negative.  Nonetheless, it’s far better now than in the past and if the Fed continues on this path, real rates should be positive soon.

  1. Low or No Volatility: The below chart shows the Barclays 1-3 Year Treasury Index.  How much volatility or drawdown risk do you see?

The answer, of course, is very little.  Holding cash and short duration bonds won’t make you rich, but it definitely allows you to sleep well at night.  Since 1992, the 1-3 year Treasury Index has had an annual volatility of 1.6% and a maximum drawdown of 1.5%.  You’re very unlikely to lose money on anything more than a temporary basis, and even then, by only a small amount.  Compare that to the belly of the yield curve, the 7-10 year space, which has an annual volatility of 6% and maximum drawdown of 8%, or the S&P 500, which has an annual volatility of 14% and a maximum drawdown over 50%.

What to Do

Many people, myself included, are feeling a little skittish about the markets right now.  The economic expansion is nearing its 10th year and the S&P 500 has gone up every calendar year for the last nine years.  As of mid-July 2018, it’s up again for this calendar year.  I would never advocate abandoning your asset allocation simply due to a gut feeling, and I continue to hold many stocks and other risky investments in our portfolio.  Yet even something like the Peace of Mind Portfolio can have a 2-8% allocation to cash and another 10-20% in short dated bonds.  Unlike years in the past, the cost of holding cash and short duration bonds is no longer very large.  Rebalancing out of stocks and holding a little more cash or holding new contributions in cash, all around the margins of a well thought out asset allocation, are perfectly prudent things to do.  Having more cash will make the next downturn much easier to stomach.

From an investment standpoint, you can do anything as simple as hold more in a money market account (make sure your money market account is passing through the higher interest rates!) or buy Treasury Bills or 1-2 year Treasury Notes.  You can buy Treasuries directly through or you can buy them at your broker for a very low cost.  There are also many good and cheap ETFs to buy.  For example, Vanguard has the Vanguard Short-Term Corporate ETF (VCSH), which targets investment grade corporate bonds in the 1-5 year timeframe.  It costs .07% and has a yield over 2.5% as of mid-July 2018.  BSV is another Vanguard product that targets the same 1-5 year timeframe but includes both corporate bonds and US Treasuries.  It costs the same but the yield is slightly lower at 1.9% due to the addition of Treasuries.  IShares has some cheap ETFs (SHY for Treasuries and CSJ for Corporate bonds) that specifically target the 1-3 year part of the curve, so they are a little shorter than the Vanguard products but also yield a little less.  IShares even has a money market like ETF (ICSH) and a T-bill ETF (BIL), all potentially worth checking out.  For high income folks, using municipal-only products can be a smart tax move and this is what I have done.  SHM, a SPDR product managed by Nuveen, has a current yield of 1.3% but an after-tax equivalent yield of nearly 2.5% for those living in high tax states.  As always, do your homework on which of these or other instruments may meet your goals.

Interest rates also impact the liability side of your personal balance sheet.  Many credit cards, mortgages, and home equity lines as well as some student loans and car loans have variable interest rates based on market rates.  These are going to go up.  If you have short-term debt or small balances on some of these, just pay them off.  They’re likely expensive debt anyway.  For some of your longer-term debt, like a mortgage or student loan, take advantage while you can and see if you can refinance into a fixed rate mortgage.  Interest rates are still relatively reasonable, but the peace of mind from locking in the rate now can be valuable.  Always proactively manage both your assets and your liabilities.

Don’t Shun Cash

For the last 9 years or so, cash has earned zero and the market has shot straight up.  Well, the market may still shoot straight up from here but cash is no longer zero.  It’s no longer that painful to hold onto cash and short duration bonds.  They provide optionality in your portfolio, have positive nominal returns (and rising real returns), and a very low risk of losing money.  In other words, they are a more viable alternative today than they have been for the last decade.

Keep building my friends.


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