Why buy bonds when cash yields 5%?

by | Oct 26, 2023

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Many investors are wondering: is it worth bothering with bonds? Two reasons stand out in their favour, writes Duncan Lamont, Head of Strategic Research at Schroders.

It’s now possible to earn interest rates of 5% on cash deposits in the US and UK, and 3-4% in Europe. This is pretty similar to what can be earned by investing in government bonds. High quality (investment grade) corporate bonds yield more, nearly 6.5% in the US and UK and 4.6% in Europe.

But bond prices can go up and down whereas cash doesn’t. This has led many investors to wonder: is it worth bothering with bonds? Two reasons stand out:

1.The short run vs the long run

This is the big one. You might be able to get 5% on cash right now but what will you be able to get in a year’s time? Or five years’ time? Putting your money in cash means you are exposed to what central banks do to interest rates in the future, sometimes described as “reinvestment risk”. And short-term interest rates are not expected to stay at current levels for the long term, even if they’re unlikely to fall back to the ultra-low levels seen in recent years.

For example, the median expectation of the US Federal Reserve’s rate setting committee’s is that their main policy rate will be 2.5% in the long run. That’s a lot less than the current 5.25-5.5% range.

In contrast, if you buy a bond and hold it until it matures, you lock in that rate of interest over the longer run (assuming the issuer doesn’t default, which has historically been a reasonable assumption for government and high quality corporate bonds). The price can move around in the short run but that matters less if you are investing for the long run.

Bonds provide that greater certainty of long-term returns versus cash. You can get around 6.5% on high quality US corporate bonds with an average maturity of ten years. For investors who don’t want to tie up their money for as long, you can get 6.2% on shorter-dated corporate bonds with an average maturity of three years. Those who are prepared to take on more risk can get around 9.5% in high yield debt (average maturity five years) and emerging market debt (average maturity 12 years).

All of these are a lot higher than estimates of where cash rates will settle over time.

“I hear you” you might be thinking “but I’m happy in cash right now. I’ll invest in bonds when cash rates fall back”. Unfortunately, it doesn’t work like that. Markets are forward looking and by the time that central banks are cutting rates by much, bond yields will probably also be lower than they are today. A “wait and see” approach could lead to missed opportunities.

2. Recession risk

If things get ugly on the economic front, central banks are likely to cut interest rates to stimulate demand. If this happens, interest rates on cash deposits will follow them lower.

This will also likely lead to lower bond yields as the market starts to price in those rate cuts. Government bond prices will rise. Cash returns down, bonds returns up has been the historical playbook in this scenario. Even if central banks don’t cut rates, e.g. if they remain concerned about inflation, safe-haven buying could send government bond returns higher.

It’s not quite as clear cut for corporate bonds. In this scenario, investors will probably demand an increased premium to lend to companies given the economic uncertainty. Corporate bond yields won’t fall by as much as government yields and could even rise. This is less of a risk for higher quality corporate bonds than riskier high yield debt.

Summary

Many investors have been drawn in by the appeal of high interest rates on cash deposits. But this is an unfortunately short-term view of investing. For those with a longer-term perspective, bonds can lock in higher yields for longer, without the need to take on lots of credit risk.

For those who are prepared to take on extra risk then even higher yields can be earned. But if that sounds like you, you’re probably not sitting in cash right now anyway.

Note: all yields quoted in this article are as at 23 October 2023. Yields are for USD-denominated bonds unless expressed otherwise. GBP-corporate bond yields are very similar. EUR ones are typically around 1.5% lower.

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