Why bonds can play a key investment role despite high cash rates

It’s now possible to earn interest rates of 5 percent on cash accounts in the UK and US, and 3-4 percent in Europe. This is pretty similar to the interest (yields) available on government bonds.

High-quality (investment grade) corporate bonds yield more. They currently provide income of nearly 6.5 percent in the UK and US and 4.6 percent in Europe.

But bond prices can go up and down whereas cash doesn’t, which could lead many people to wonder whether they should invest in bonds at all. Two reasons stand out for why you should consider them.

Good long-term prospects

First, you might be able to get 5 percent interest 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 future central bank interest rate decisions, 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 general expectation of the rate-setting committee of the US Federal Reserve (Fed) is their main policy rate (or interest rate) will be 2.5 percent in the long run (1). That’s a lot less than the 5.25-5.5 percent range we see today.

If you buy a bond and hold it until it matures, you lock in its rate of interest for the longer run. But this assumes the issuer doesn’t default on the loan, which has historically been a reasonable assumption for government and high-quality corporate bonds. The price can move around in the short run (bond prices rise when bond yields fall, and fall when bond yields rise) but that matters less if you are investing for the long run.

So bonds may provide greater certainty of long-term returns than cash. You can currently get around 6.5 percent interest 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 so long, you can get 6.2 percent interest on corporate bonds with an average maturity of three years. Those who are prepared to take on more risk can get yields of around 9.5 percent in riskier high yield debt (with average time to maturity of five years) and emerging market debt (with an average time to maturity of 12 years).

All of these yields are a lot higher than the Fed’s estimates of where interest rates will settle over time.

Steve Mann, Head of Investment Specialists at Schroders Personal Wealth (SPW), said, ‘Investing is about looking forward and not always looking in the rear view mirror. Yes, it’s good to learn the lessons of the past but investors and markets need to look to the future. In my view, bonds currently offer excellent long-term return prospects with interest rates looking at or near their peaks in many developed markets. If rates peak and the market anticipates this, then bonds should start to rise in value.’

‘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. If and when central banks cut rates materially, bond yields could also be lower than they are today, as bond yields often fall when interest rates go down. A ‘wait and see’ approach could lead to missed opportunities. Indeed one of SPW’s principles is to spend time in the markets, rather than try to time the markets.

Cash deposits face recession risk

When economies faces challenges, central banks often cut interest rates. So if global economies do face recessionary pressures, then interest rates on cash accounts could well fall.

This could also likely lead to lower bond yields (and higher bond prices), as bond yields often fall when interest rates decline. But even if central banks don’t cut rates, government bond prices could rise in challenging economic times, when investors typically seek the security of government-backed bonds.

The situation is not as clear cut for corporate bonds. Yes, corporate bond yields often fall when interest rates fall. Even so, corporate bond yields typically don’t fall by as much as government yields when central banks reduce interest rates. In fact yields could even rise. This is because challenging economic times often lead investors to demand higher interest (higher yields) on loans they make to companies, to compensate them for the higher economic risks companies face. This is less of a risk for higher quality corporate bonds than for riskier high yield debt.

High interest rates on cash deposits can have an obvious appeal to investors, especially for savings they might need to access in the short term. But for those with a longer term perspective, bonds can lock in higher yields for longer.

Even so, one of SPW’s key principles concerns the benefits of diversification, of not having all your eggs in one investment basket. So, in SPW’s view, bonds should generally be held as part of a diversified portfolio of investment assets, in line with your financial circumstances.

Steve said: ‘I have been working in financial markets for 37 years and the returns available on bonds are now back at levels that I last saw in 2008. So now could be a really good time to be investing in bonds if this fits in with your overall financial planning needs.’

Note:

All yields quoted in this article are as at 23 October 2023. Yields are for bonds priced in US dollars unless expressed otherwise. Yields on corporate bonds priced in UK sterling are very similar. EUR ones are typically around 1.5 percent lower.

Source:

(1) Forbes.com, ‘Fed pauses interest rate hikes again but ups long-term forecast’, 20 September 2023.

This is a revised version of an article published on the Schroder Investment Management (SIM) website on 24 October 2023.