As we wait on the Fed’s decision of whether or not they will raise rates this month, a common question becomes "am I better served by sitting in cash for the time being rather than being in bonds?" For those who don’t understand the relationship, if everything else remains the same, as interest rates increase, bond prices to go down.
If we believe rates will go up, whether later this month or later this year, why would anybody hold on to bonds? As the logic would go, it would seem much better to roll into something like cash and wait for bonds to fall.
For starters, be careful to not underestimate the markets and in particular the bond market. For better or worse, the Fed has become much more vocal in setting expectations and the increase in rates is far from a secret. So while the Fed Funds Rate has not officially changed, bonds have already largely adjusted for the increase. While the difference between a September and a December rate increase is important, what will be far more important to the price of bonds is the language the Fed uses in the announcement. If they indicate that future increases are unlikely in the short term, bond prices most likely will remain fairly stagnant. If, however, they indicate that they would like to accelerate the increases (unlikely given the current economic environment), bond prices could fall.
Furthermore, the reliability of bonds is in their structure. Unlike stocks, bonds have a known value at any given time. When they mature, you will receive the par value back and a fixed amount of interest back while you wait (there are floating rate bonds, but we can worry about those at another time). This is why bonds are so much more stable than the stock market. Consider the chart below:
Source: "Stay the Course." Pimco. https://www.pimco.com/search/?q=worst%20market%20declines.
The worst calendar year for bonds in the past nearly 30 years has been less than a 3% drop. This is one of the fundamental reasons bonds play such a crucial role in a portfolio. While there is always a risk of your bonds falling in price, do not overestimate the risk. A well-diversified bond portfolio should always represent a fraction of the volatility of any portfolio mixed with stocks.
Last is a constant warning of mine, be wary of cash. Yes, in theory, it is possible to sell any asset: wait for it to drop and then buy it back at a lower price to give you better returns. Yet, in practice, this is incredibly difficult, wildly unreliable, and inconsistent. This is compounded by the fact that cash earns very little in the current environment. A quick review of a savings account at Bank of America reveals an interest rate of 0.03% and a jaw-dropping 0.07% rate for a twelve month CD. Cash is quickly being engulfed by inflation and your savings is losing its purchasing power. Even using a conservative bond index like the Bond Aggregate has a yield to maturity of 2.3%, roughly 77 times the amount of a savings account.
While it might be tempting to try and manage around a rising interest rate environment, be cautious of overestimating the volatility of bonds and underestimating the safety of cash. For those of us who maintain a long-term focus, rising interest rates are a normal and healthy part of a market cycle and do not need to be something feared.
"Bank Account Interest Rates." Bank Of America. September 4, 2015. https://www.bankofamerica.com/deposits/bank-account-interest-rates.go.
"iShares Core U.S. Aggregate Bond ETF." iShares by Blackrock. September 3, 2015. https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-etf.