With cash and bond yields near 15-year peaks, you might wonder whether you should increase your weighting to fixed-income investments.
Morningstar’s director of personal finance, Christine Benz, took a look at the issue in a recent internal interview.
As for cash — money-market funds, certificates of deposit and savings accounts — “the yields are certainly compelling,” she said. Many money-market funds yield more than 5%.
“In many cases, the yields are better than what you can get on certain bonds and bond funds. That’s an obvious attraction.” Five-year Treasury bonds yield 4.29%.
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Another attraction is safety. “We’ve seen significant principal-related losses for some bond investors over the past couple of years,” Benz said.
“If you’re a cash investor, you don’t have that volatility in terms of principal value. Liquidity may also be an attraction, and that goes hand in hand with the idea that you have safety and principal stability.”
The disadvantages of holding cash
What about the disadvantages of holding cash?
“One of the key ones is that these yields are ephemeral,” she said. “The high yields on offer today may not be available in the future.”
To be sure, you can lock in a favorable yield on a long-term CD. A five-year brokered Morgan Stanley CD yields 5%.
“Another consideration is inflation risk,” Benz said. “Over very long periods of time, cash yields sometimes beat inflation but not always.”
Advantage of bonds: higher yield for longer
What are the advantages of bonds and fixed-income?
“One is that you are able to lock in a higher yield for longer,” she said. “Another is you have some appreciation potential with fixed-income instruments, which is something you don’t have with cash instruments.”
Given the potential for lower interest rates — markets are expecting the Federal Reserve to cut rates soon — “the fixed-income investor stands to benefit from [bond price] appreciation in such an environment.”
And what about equities? On the upside, “stocks, of course, have unlimited upside potential,” Benz said. “When we look at the asset classes that have had the best long-range opportunity to outrun inflation, stocks have certainly done that, and then some.”
On the downside, stocks have “significant principal volatility potential,” Benz said. “You need to be prepared for that.”
Asset Allocation: How much to put where
All this raises the question of how you should allocate your assets among cash, stocks and bonds. Benz recommends matching investment weights to your time horizon as your first consideration.
“I typically think of cash being appropriate if you have a very short-term time horizon for your funds — maybe a couple of years,” she said.
And then for money you’re holding for two to six, or even two to 10, years, she recommends bonds. For six to 10 years and beyond, she recommends equities.
Personal risk tolerance is another factor. “I have a lot of tolerance for the principal-related volatility [of stocks],” Benz said. “But other people have much less appetite for that volatility.”
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