Cash and bonds are different investments

A mistake even experienced investors make is to think of bonds and cash as identical.

Bonds are not the same as cash. Confusing the two is a bit like mixing up a bicycle with a unicycle. Yes, both have wheels. But one will give you a much smoother ride than the other.

For instance I once heard David Kuo, then head of personal finance at The Motley Fool UK and a frequent radio personality, mix up cash and bonds in a (now deleted) podcast.

Quoth Kuo to his guest:

“Do you buy into that rule of thumb that says that you express your age as a percentage, and that should be the amount of your portfolio allocated to cash? So somebody who is 20 years of age should have 20% of their portfolio in cash, a 30-year-old should have 30%, and so on and so forth?”

But as we’ve previously explained, the rule of thumb is to hold your age as bonds – not cash.

Similar idea, but potentially very different in practice.

This is not to pick on Kuo. I’m sure it was just an honest slip and Monevator is hardly not error-free. But I think it was telling mistake.

The fund manager Kuo was interviewing later pointed out the flaw in substituting cash for bonds:

“I wouldn’t necessarily say cash either, cash has not generated such good returns as fixed interest over the very long term, so you’re better off probably suffering a liquidity risk with fixed interest investments, rather than cash.”

Here liquidity risk means the chance that your investment will be worth less than you paid for it at any particular point in time, due to the fluctuating market value of bonds.

This risk is just one of several important differences with cash.

On the other hand, as the manager says bonds have delivered higher real returns than cash over the very long-term.1. And that difference in return profile is the other crucial distinction.

So yes bonds are more volatile than cash. Sometimes gut-wrenchingly so.

That’s exactly why bonds have historically delivered superior returns.

Cash and bonds: different investments

Cash has several key attributes:

• Cash is the least risky asset class. Cash is king!
• Cash doesn’t fluctuate in value (except versus other currencies).
• Cash pays a varying rate of income that shifts with market interest rates, competition between banks, and so on.
• Cash is extremely liquid. You can typically transfer it from one person to another without any trading costs instantly. And you can withdraw it from a current account on demand.
• There are special protections for cash savings accounts for consumers. See the Financial Services Compensation Scheme.
• Very long-term returns from cash are poor – in the UK only about 1% ahead of inflation.

Someone may be about to say something about inflation here, and how this is a big risk of holding cash.

But inflation is an equal opportunities wealth-sapper in its ability to erode real returns.

Everything is affected when a £1 today is worth 90p next year. Cash obviously. But also a share price, say, or the value of your home.

Yes equities have been a better defence against inflation than cash – but that’s because their total returns have historically been much higher. A nominal 10% return from equities still becomes a 5% real return when inflation is at 5%, just the same as a 5% return from cash becomes 0% in real terms.

So if you have reason to hold a chunk of cash instead of buying more equities or bonds or anything else (say for safety, emergency fund, portfolio ballast, diversification) then inflation is kind of moot.

Turning to bonds:

• Bonds fluctuate in value – the price of a bond goes up and down between its issue and its eventual redemption. This makes bonds riskier. (See my old piece on what causes bond prices to vary).
• Bonds can default which also makes them riskier than cash. Highly-rated UK government bonds are assumed to be risk-free (because the government can always print more money) but they are still riskier than cash, which has no default risk. Corporate bonds are much riskier than cash.
• Bonds are less liquid than cash. You’ll need to buy and sell your bonds via a broker, who will charge a fee.
• Bonds pay a fixed interest rate (usually).
• Bonds repay their par value on redemption (unless they default, and without getting into the complications of linkers).
• With government bonds your protection comes down to the ability of the issuing government to meet its obligations. (And separately, any investor protections that apply to the platform you’re holding the bonds on.)
• Very long-term returns (50 to 100 years, say) from bonds are better than cash, but timing plays a part over the short to medium term.

As you can see, quite a difference!

Confusion marketing

I understand where the confusion between cash and bonds comes from.

Private investors – especially old-school stock picker types – tend to think either ‘equities or not equities’, rather than considering cash as a separate asset class. Let alone grappling with the different types of bonds, the intricacies of duration, or other bond-nerd-o-terica.

Meanwhile institution investors moving around vast quantities of assets typically don’t have the option of going to cash for any meaningful period. Instead, when they ‘go liquid’ they typically go into short-dated government treasuries, which are ‘cash-like’ investments but are not cash.

Company reports use terms such as ‘cash-like’ or ‘near-cash’ when describing their assets, too.

It’s sometimes an appropriate shortcut to lump cash and bonds into the same – very wide – basket, but we need to remember when and why we did so, and to know when it’s definitely inappropriate.

Cashing up

The fact is you could put £10,000 into very long-dated – say 30-year – UK government bonds yielding 5% and I could put £10,000 into a bank account paying 5% and after a year your bonds could be worth almost anything – thousands of pounds more or less than you paid – while my cash would still be worth £10,000.

That’s the intrinsic risk of bonds.

Now, if you held your 3o-year bonds until they matured and we both kept spending all our income, then after 30 years you’d redeem your bonds and have the same amount of money as me: £10,000.

But if you needed to sell your bonds in-between?

Finger in the air time.

Note though that while I am ignoring income for simplicity and to make a point, over the long-term doing so is really unfair on bonds. That’s because the known-in-advance income stream from bonds is a huge component of what de-risks them as an asset class.

Thanks to the knowable elements of a bond’s future returns (the redemption value and coupon rate) you can pretty confidently approximate your long-term returns at the very moment you buy.2 Rather than it being a crapshoot like with equities, or even cash. (Interest on cash varies, whereas a bond coupon is fixed).

• See our article on whether you should hold cash or bonds for more on this. (And remember the answer is often ‘both’!)

Horses for courses

To confuse matters in conclusion, you will sometimes hear high-falutin’ types who read Monevator (or who write it) describing cash as like a zero-duration bond.3

What they mean is that in having no maturity date, cash is like a bond that continually matures in the next micro-moment.

This mental accounting has some useful side effects. For example, it makes it obvious that one way to reduce the overall riskiness of your bond portfolio is to swap some of your bonds for cash. This reduces the average duration of your bond bucket, and hence how much it fluctuates with interest rate moves.

However as I’ve listed above, even a zero-duration bond – a bond that matures tomorrow, say, in practical terms – has a different risk profile to cash.

Sure, if I had to pick the asset most like cash – the safest, most liquid, and hence most ‘cash-like’ in the world – I’d choose very short-term US government bonds, hedged to your local currency. (And recent ratings downgrades be damned!)

The chances of you not getting your money back on those are tiny. You’d be paid an income, too.

Similarly, if you want to mix-up the non-equity holding part of your portfolio then diversifying beyond bonds into cash (or vice versa) is a logical first step.

But similar is not the same as identical. And as soon as you add any meaningful duration to the bonds in question, the differences become pretty clear.

Both cash and bonds are valuable assets precisely because they can play different roles in your portfolio. (Yes, even after the bond rout of the past 18 months.)

Cash and bonds are not the same.

1. At least if you ignore any hard-to-calculate boost from rate tarting your money from one best buy savings account to another [↩]
2. The reason you can’t ‘perfectly’ calculate the future return is you don’t know what price your bonds will be trading at as you come to reinvest that income over the years. [↩]
3. Specifically a floating-rate bond, as the interest rate varies. [↩]