Cash vs. Bonds: An Overview
With the bull market in the U.S. economy now over 10 years old and talk of a pullback, many are more concerned with protecting the money they have than with growing additional wealth. There are a number of investment vehicles touted as "safe" places to store savings, but many people feel nothing could ever be as safe as cash. The security of knowing exactly where your money is, such as safely stowed away in a federally insured checking or savings account, is undoubtedly appealing.
However, with the risk of inflation potentially rendering today's dollars significantly less valuable down the road, many low-risk, modest-reward investments continue to be popular among investors looking to put their money to work without incurring too much risk. Bonds, in particular, have long been heralded as one of the safest investments available because they guarantee the return of principal while still generating periodic interest payments.
Holding cash and investing in bonds are both viable options for those looking to protect their savings from a volatile market. However, it is important to understand the risk and rewards of both options to ensure you choose the investment strategy that best suits your needs.
- Holding cash and investing in bonds are both ways for cautious investors to protect their wealth, even if the economy takes a turn for the worse.
- Cash is readily available and typically insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per banking institution where deposits are held.
- Cash does not earn any return in and of itself and so inflation can erode its buying power over time. Sitting in cash also presents an opportunity cost as it forgoes potentially better investments.
- Bonds provide interest income that often meets or exceeds the rate of inflation, and with the potential for capital gains if bought at a discount.
- Bonds, however, do have some inherent risks and could lose value if the underlying issuer goes bankrupt or if interest rates rise.
The primary benefit of keeping your money in cash is the obvious advantage of maintaining complete control. If you simply deposit your cash into a bank or savings account, you can easily review your balance and transaction history with the click of a button, knowing that no one but you has access to those funds.
In addition, checking and savings accounts at almost any bank are insured through the Federal Deposit Insurance Corporation (FDIC) for up to $250,000. While banks are not required to purchase this coverage, it has become such a ubiquitous symbol of a bank's quality that any institution that is not FDIC-insured is not likely to do well. Accounts at federal- and state-chartered credit unions are also insured up to $250,000 through the National Credit Union Administration (NCUA). Even if your savings exceed this limit, it is possible to ensure all your deposits by opening multiple accounts at different institutions.
Another advantage of keeping cash is it provides ultimate flexibility in times of stress. If you need to access your funds in the near future, such as within the next three years, holding cash is the best way to ensure that you have the money whenever you need it. Though investing offers the possibility for profits, it can also put your funds at significant risk, meaning you may not have the money you need on short notice.
Risks of Cash
The biggest risk you incur when holding cash is the risk of inflation. If interest rates rise, the money you have now may have significantly less buying power in the future. This is the main reason that most investors allocate much of their cash holdings to cash-equivalent money market accounts or mutual funds. Though these types of highly liquid investments generate only a modest amount of interest, it can be enough to offset the effects of inflation over time.
The other disadvantage of holding cash is it carries a significant opportunity cost. Opportunity cost refers to the forfeiture of potential profits that could have been generated had you used your money in a different way. Since holding cash effectively generates zero profit, the opportunity cost of this strategy can be quite high. This is known as cash drag in a portfolio. Given all the different investments available that generate guaranteed income, such as bonds and certificates of deposit (CDs), holding cash means you might be giving up the opportunity to reap significant returns.
Both cash and bonds are vulnerable to rising interest rates; higher rates sap the cash from some of its buying power and lower the value of the bond.
Unlike holding cash, investing in bonds offers the benefit of consistent investment income. Bonds are debt instruments issued by governments and corporations that guarantee a set amount of interest each year. Investing in bonds is tantamount to making a loan in the amount of the bond to the issuing entity.
In exchange for this loan, the issuing company or government pays the bondholder monthly, quarterly, semi-annual or annual coupon payments equal to a set percentage of the bond's par value. The income generated by bond investments is stable and predictable, making them popular investments for those looking to generate regular income.
Once a bond matures, the issuing entity pays the bondholder the par value of the bond regardless of its original purchase price. Investing in bonds offers the potential for capital gains if a bond is purchased at a discount, as well as interest income.
Bonds carry varying degrees of risk depending on their maturities, which can range from a few months to several decades, and the credit rating of the issuing entity. Investors can choose which type of bonds to invest in based on their goals and risk tolerance. In times of economic instability, bonds and other debt instruments issued by the U.S. Treasury are considered extremely safe because the risk of the U.S. government defaulting on its financial obligations is minimal.
Similarly, bonds issued by very highly rated U.S. corporations are typically very low-risk investments. Of course, the interest rates paid on these high-quality bonds are often lower than those paid on junk bonds or other risky investments, but their stability may be worth the trade-off.
In addition, bonds issued by state, and local governments are typically not subject to federal income taxes, making them one of the more tax-efficient investments available.
The biggest difference between bonds and cash are that bonds are investments while cash is simply money itself. Cash, therefore is prone to lose its buying power due to inflation but is also at zero risk of losing its nominal value, and is the most liquid asset there is.
The primary risk of bond investing is your investment loses value. If an issuing entity defaults, you may lose some or all of your investment. While bondholders have a higher claim on company assets than stockholders, the likelihood of receiving the full value of your bond after a company declares bankruptcy is low since it likely must first pay off its loans, mortgages and other debts.
Your bond may also lose value if rising interest rates render it worthless on the secondary market. If new bonds are issued with higher coupon rates, the market value of your bond declines. However, this is only a concern if you are looking to trade your bond before maturity. If you retain your bond until it matures, you are paid its par value regardless of its current market price.
Unlike keeping your money in a checking or savings account, any investment in bonds is uninsured. Just like stocks or mutual funds, you voluntarily take on a certain degree of risk when you purchase bonds. Because of this, the FDIC does not insure these investments. If you lose money on bond investments, there is no way to recoup your losses. However, you can largely mitigate this risk by investing in highly rated bonds and holding them until maturity.