Vanguard analyst: Cash isn't king

Outlook for bonds is grim, but sticking with them over the long term will pay off, Phillips says

By Jason Kephart

Jul 30, 2013 @ 9:40 am (Updated 1:01 pm) EST

bonds

The outlook for fixed-income is about as grim as it has ever been, but that doesn't mean that investors should be thinking about heading to cash, according to The Vanguard Group Inc.

Since interest rates spiked in May and again last month, investors have been doing just that.

Assets in money market funds have grown by $64 billion since the beginning of May, when the 10-year Treasury was yielding 1.66%. It has since shot up to more than 2.5%, causing the Barclays U.S. Aggregate Bond Index, the benchmark of investment-grade credit, to fall by about 2.2% year-to-date.

The volatility in the bond market has led to a bond sell-off, with $66 billion being pulled out of all bond funds since the beginning of May, according to the Investment Company Institute.

The problem is, though cash means principal protection, financial advisers would be missing out on yield while they waited to time their way back into the market.

“The biggest challenge with moving to cash is, you're expecting to time interest rates better than everyone else out there,” said Chris Phillips, a senior investment analyst at Vanguard.

“We've found pretty consistently over time that the vast majority of active bond portfolio managers can't even do it,” he said. “If you're an adviser, without the same tools, that's a huge hurdle to overcome.”

Holding onto investment-grade bonds is still going to take a strong stomach.

Vanguard looked at what would happen to a portfolio of investment-grade bonds if rates were to rise 300 basis points — considered the worst-case scenario today but not the biggest single-year increase ever.

The year of the rise wouldn't be pretty. The portfolio would lose about 13%.

After two years though, with interest payments re-invested, the total return would be negative 8.5%. In fact, the longer the portfolio were held, the rosier things would get.

After the fifth year, the portfolio would have a total return of 6.3%.

“If you're reinvesting dividends you can be back in black in a fairly reasonable amount of time,” Mr. Phillips said.

The good news is that there is no driver in the market that could lead to that kind of worst-case scenario at this time, he said.

“You have to think about the likelihood that rates continue to go up, making cash the true loss avoidance vehicle you think it would be,” Mr. Phillips said.

Inflation looks tame and with Europe in a recession, Japan's problems, and emerging markets struggling from little global growth, the United States still looks like the best bet in the world, meaning that rates probably aren't on a skyward trajectory at the moment, he said.