Bonds Commentary

Bonds: Cash Considerations

November 2023

  • Cash and short-term bonds understandably hold greater appeal with yields above 5%, but there are tradeoffs that must be understood as cash can be far from a risk-free investment when viewed through a total return lens by investors with longer time horizons.
  • Corporate bonds have held up quite well considering the back-up in Treasury yields over the past month and a half as credit spreads have remained in check and current yields are well below average versus comparable Treasuries, indicative of solid demand.
  • Treasury yields stabilizing into year-end could provide a tailwind for both investment-grade and high yield corporate bonds over coming months, but we prefer to hold higher quality bonds into what we expect to be a challenging first half of 2024.

Cash Vs. Bonds: Beware The Sirens’ Song Of Short-Term Rates. Elevated yields on cash and ultra short-term bonds have lured investors to the front of the Treasury curve in 2023, and the call to ‘get short’ has grown louder in recent months as Treasury yields have risen sharply, leading to paper losses on longer duration bonds. The rise in long-term Treasury yields has led some investors to discard their strategic allocations to bonds in favor of cash, but that decision has tradeoffs that must be considered. Yields on longer-term bonds are a far more prescriptive measure upon which to base future return expectations than are yields on shorter-term bonds, which often prove fleeting as interest rates change. Thus, it’s more likely that an investor in the Bloomberg Aggregate Bond index will experience a total return at least in-line with the index’s current 5.3% yield over the next 7-10 years than it is that a holder of cash will experience a comparable rate of return, despite similar starting points for yields.

A vital consideration when holding cash is that investors are rarely compensated with a yield above inflation for holding risk free assets, and while the current backdrop may seem like a ‘free lunch,’ it isn’t likely to play out that way over coming quarters. As has been the case in past cycles when short-term yields were elevated, the Fed ultimately cuts when the economy weakens and/or inflationary pressures subside, and the market usually moves to price in that sequence of events early-on, which is why peaks in long-term yields often occur prior to the first rate cut. If an investor waits for the first rate cut as a signal to buy longer-term bonds, they will almost certainly show up late to the party and likely miss out on a sizable gain as investors with deep pockets and long duration liabilities clamor to lock in higher rates before policy rates are cut and yields fall. The decision to hold cash in lieu of bonds in one’s investment portfolio is not to be taken lightly, even with cash yields over 5% at present, as investors must be willing to take on reinvestment risk with a potentially sizable opportunity cost to boot. An outsized cash position might make sense given an individual investor’s specific circumstances, spending needs, etc., but the pros and cons must be weighed and measured before going that route.

Carrying a portfolio duration that is ‘too long’ versus one’s benchmark is preferable to being ‘too short’ as yields on long-term bonds will likely track short-term rates lower over the next year, but with longer duration bonds the total return benefit from such a move would be far more impressive. However, we don’t view duration management as a sustainable source of generating excess returns from fixed income and very few active managers have proven to be consistently good at timing interest rate inflection points. This is why we recommend a portfolio duration profile in-line with that of the Bloomberg Aggregate Bond index, relying instead on sector and security selection to drive excess return.

The Case For High Grade Corporates Grows Stronger As Treasury Issuance Rises. If the Bloomberg Corporate index’s yield to-worst (YTW) relative to Treasuries, which is currently well below its historical average despite elevated economic and geopolitical risks, is any indication, investor’s view investment-grade (IG) corporate bonds as better stewards of capital and more worthy of investment than U.S. government securities of similar duration. Capital tends to flow to where it is treated best, and the yield relationship between investment-grade (IG) corporates and U.S. Treasuries is telling in that regard.

Corporations took advantage of ultra-low interest rates in recent years to term-out debt, and as a result have the capital on hand and flexibility to wait for more enthusiastic and receptive markets before refinancing or issuing new debt. The U.S. Treasury, however, does not have this luxury. Also, the interests of Chief Financial Officers are closely aligned with shareholders as the maximization of profits is a function of optimizing a company’s capital structure. In sharp contrast, the U.S. Treasury is tasked with issuing debt to fund Congress’ spending plans and doesn’t take the wishes of taxpayers into consideration. All told, while we understand why investors might gravitate toward IG corporates relative to Treasuries in the current environment, there remains a place for both in a diversified fixed income portfolio as Treasuries would likely benefit relative to corporate bonds should the economic backdrop deteriorate and investors dust off the recession playbook.

As of November 8, 2023


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