Wednesday, December 19, 2018

Cash or Bonds at Low Yields and a Flat Yield Curve?

The End of an Era?

While there have been a few cyclical periods of rising rates over the past 40 years, we've largely been in one large downtrend... meaning that it has consistently paid to own bonds vs cash** or take duration risk for nearly my / many investment lives. 

Now that we've moved away from a zero interest rate policy on cash in the U.S. and the yield curve is essentially flat, this post is an attempt to pose the question of whether it still makes sense own bonds at the same scale.

The Historical Benefit of Extending Duration

Mapping the forward 10-year return of t-bills, a constant maturity 5-year Treasury bond, and a 10-year constant maturity Treasury bond against the starting yield of the 10-year Treasury, it should come as no surprise that 1) higher nominal starting yields have led to higher forward returns and given the yield curve is usually upwards sloping, that 2) longer duration bonds have generally outperformed shorter-duration bonds given their higher starting yield. 

The data in the chart above may be more easily digested when the average forward returns are "bucketed" by the starting yields of less than 4%, 4-8%, and more than 8%. Here we can more clearly see that the benefit of bonds / duration historically occurred when rates were quite elevated. 

Adjusting for a Flat Yield Curve

What the above chart does not account for is the relative starting yield of t-bills, the five year Treasury bond, and the 10 year Treasury bond. The below charts "adjust" the returns of t-bills and 5 year Treasuries to a yield equal to the starting yield of the 10 year Treasury. For example... if at T=0 t-bills yielded 1% and 10 year Treasuries yielded 3%, I added 2% / year to the t-bill ten year return. This is obviously inexact given it assumes the path of yield movements are identical in each situation despite the different yield levels.

And again... adjusted returns bucketed by starting yield of the 10 year Treasury. Now we can see the improved opportunity for cash / reducing duration; an investor can potentially (if history is a guide and this framework makes sense) reduce risk, while capturing similar (or potentially increased) return.

For those focused on tactical asset allocation, bonds are likely to outperform cash if we enter a deflationary / disinflationary environment, while cash will likely outperform if markets continue to normalize or if there are inflationary pressures. Rather than pretend to guess which situation is more likely, I would frame it as follows... are investors being fairly compensated for the increased volatility to own bonds vs cash?

With cash, you know the value will increase by the short-term rate, you just don't know what that short-term rate will be in the future. Importantly, the daily volatility of cash can be assumed to be pretty much 0% irrespective of what happens in the market. With bonds, you know roughly what that the nominal return will be, but you don't know if that return will compensate you over cash. As important, the value of bonds will fluctuate daily (historical volatility has been ~6% for 10 year Treasuries).

So, while the risk of owning bonds has likely been exaggerated for longer-term holders, there is a real increased risk of ownership relative to cash. Whether it’s the risk of less proceeds available when it comes to reallocating to other opportunities / taking withdrawals or the behavioral impact of a fluctuating account value, it’s a risk. So, if you believe the return of cash / lower duration bonds will be the same (or more) than bonds, why take that risk?

** in the above analysis I considered t-bills as a cash equivalent because they are liquid and not subject to material fluctuations in value