Why bonds—and not cash—endure in retirement plans

This backdrop has been a tailwind for cash and other short-term investments—with yields north of 5% as of mid-2024—and has attracted a lot of investor interest. In hindsight, an overweight to cash since the onset of interest rate hikes has paid off for many investors given cash's lower interest rate sensitivity compared with longer-duration bonds. Vanguard Cash Reserves Federal Money Market Fund, for example, has returned more than 9% cumulatively from mid-March 2022 through June 2024, while Vanguard Total Bond Market Index Fund, a measure of the broad U.S. bond market, lost more than 3% during the same period. While cash outperformed bonds over the last couple of years, it's important to understand why this is highly unlikely to continue over the long term. 

Investment decisions have trade-offs. Those who invest in cash have a primary goal of preserving principal. Cash or cash equivalents are readily available short-term financial instruments that are highly liquid, have minimal or negligible market risk, and have a maturity within 90 days.²  When investors choose to invest in cash, they will generally maintain their principal while earning interest income with low return volatility. The trade-offs, however, can include reinvestment risk, lower long-term returns, low to negative real returns because of the effects of inflation, and reduced portfolio diversification when needed most.

Normally, bonds with longer maturities require higher yields to compensate investors for additional risks. Occasionally, there are periods when this relationship doesn't hold, as we see today, and investors can earn more income in cash and short-dated bonds than in longer-dated bonds. We do not believe that trend is sustainable.

As of June 30, 2024, 1-month U.S. Treasury bills were yielding 5.5%, while 10-year U.S. Treasury bonds were yielding 4.4%.³  This can be an attractive proposition for many investors, but remember that different maturity profiles can result in differing long-term return expectations. In the case of the 10-year bond, investors would be receiving a yield of 4.4% per year for the next 10 years if that bond were held to maturity. In the case of the 1-month Treasury bill, investors would receive an annualized rate of return of 5.5% for the next one month.  When the original principal is received one month later, at maturity, the market rate for reinvestment is unknown, as yields could be higher or lower. Therefore, reinvestment risk may be associated with the one-month investment compared with the 10-year investment over the next decade. The risk is that if yields were to fall, the investor would begin to earn a yield lower than what they could have earned by investing in the 10-year bond. While longer-dated bonds generally have more yield durability, all investors should consider their time horizon when making investment decisions.

Longer-dated bonds typically provide higher income, a key driver of their superior long-term returns compared with cash, as most of a bond investor's total return comes from earned income. During the last 30 years, the average annual return of the broad U.S. bond market has been 4.4%—more than double the return of cash. Furthermore, the Consumer Price Index, a measure of broad-based inflation, averaged 2.5% over the same time. Although cash and bond investors would have seen their balances increase, investors in cash lost purchasing power, or wealth, in real terms, as inflation grew at a higher annualized rate relative to cash.

In this box and whisker chart, using Vanguard's proprietary forecasting model, the Vanguard Capital Markets Model® (VCMM), we show that bonds are expected to continue outperforming cash over the long term. Even though our model forecasts a positive inflation-adjusted return for cash over the next 30 years, its limited ability to keep up with inflation considerably erodes purchasing power.

Portfolio efficiency trade-offs can also occur when asset classes are added or removed from an investor's allocation.  An allocation to cash, for example, safeguards that portion of the portfolio from market risk, but it may not pair as well with other asset classes—especially equities. While cash helps with preserving principal, it lacks duration.  Although this can be beneficial when interest rates are rising, the buffering effects of cash fade when interest rates are falling. Cash has a high, positive correlation to changes in the federal funds rate. When the economy begins to slow and equity markets sell off, there is generally a reduction in the federal funds rate to help spur economic growth. As this rate falls, cash yields fall, but bond prices rise, helping to offset unrealized equity losses. Since 1994, in periods when U.S. equities had a negative 12-month return, the median annual return of bonds was about 7.6%, versus 1.4% for cash. As shown in this bar chart, when considered in the context of a balanced total portfolio and despite their own risks, bonds have historically done a better job buffering against equity losses in down markets.

It's understandable that high-yielding money market funds might tempt some investors to hold more cash and less in bonds until the Fed begins cutting interest rates. However, bonds historically have outperformed cash over short, intermediate, and longer-term time horizons following the peak of Fed tightening cycles. The line chart shows the cumulative growth of cash and bonds following a period of aggressive Fed monetary policy during 1999 and 2000, in response to the dot-com bubble. From the date of the Fed's final rate hike on May 16, 2000, bonds returned a cumulative 87.9%, versus 34.4% for cash over a 10-year period.

We expand the analysis in the table that follows to include three other rate-tightening cycles that occurred within the past 30 years. We show the annualized total returns for cash and bonds for the 1-, 3-, 5-, and 10-year periods following the Fed's final rate hike during each respective cycle. Except for the 5-year period that ended on December 20, 2023, (which includes the recent 2022–2023 rate increases), bonds have outperformed cash by a comfortable margin. While past performance doesn't guarantee future results—and this cycle could be different—we believe bonds are superior to cash for meeting most investors' long-term goals.

When will the Fed start cutting interest rates? That's hard to predict, and the decision is not something investors can control. Plan sponsors focused on the financial well-being of their participants should approach the "cash versus bonds" debate objectively.

Cash can be a tool for managing liquidity risk, such as meeting day-to-day needs and saving for emergencies. A strategic allocation to cash may also make sense for some investors with short-term goals and low risk tolerance. However, even in today's high-yielding environment, cash investments should not be viewed as a substitute for stocks or bonds. Additionally, overweighting cash and trying to time reentry into bonds can come at the cost of long-term underperformance and the risk of falling short of one's financial goals.

Notes:

• For more information about Vanguard funds, visit institutional.vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
• Vanguard Cash Reserves Federal Money Market Fund: You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the Fund is not a bank account and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor is not required to reimburse the Fund for losses, and you should not expect that the sponsor will provide financial support to the Fund at any time, including during periods of market stress.
• All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. There may be other material differences between products that must be considered prior to investing.
• Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
• IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
• The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
• The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
• CFA® is a registered trademark owned by CFA Institute.
• Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.