Cash or bonds?

If yields were the only drivers of total investment returns, then there would be little debate on which asset to choose – one could simply allocate to the asset class with the highest yield. In today’s market, that would be cash.

However, one needs to dig a little deeper in the investment world to figure out the real value of the two competing assets. The trade-off is best illustrated with a simple example. In the chart below, we compare three scenarios over a 5-year horizon:

1. In the first scenario, an investor allocates to cash deposits, which currently yield around 5% over one year. We assume these yields stay relatively high at 5% and 4% in the first two years but fall to 2% thereafter as an economic recession unfolds and, in response, the central bank cuts short-term rates rapidly.
2. In the second scenario, an investor buys a 5-year bond that yields 4% i.e., less than the return from cash. However, in this case, the investor can lock in the 4% yield for the next 5 years till the bond matures.
3. In the third scenario, the investor buys another 5-year bond, but one that yields just 3%.

The chart illustrates how an investor’s returns pan out over the five-year period. In the first year, cash is clearly ahead with its higher yield.

However, as the one-year cash yield starts to drop in later years, returns fall rapidly. When the investor looks back with hindsight after 5 years, the 5-year bond yielding 4% (1 full percent below the cash yield) ended up being the investment that delivered the highest returns.

Cash only ended up matching returns for a 5-year bond that yielded 3%.

Leaving aside the need for liquidity, some cash can make sense within an investment allocation. This was not really the case for a large part of the previous cycle when cash yields largely went to zero. However, ever since central banks began to raise rates rapidly, cash has become a little more competitive.

Nevertheless, there is little reason to expect cash to do a better job of preserving wealth in real (or inflation-adjusted) terms compared with riskier asset classes. The Optical yield illusion is making many investors respond to the headline yield on cash, but high-quality bonds are the hidden gems that are likely to outperform cash and better keep up with inflation over the coming years.