What caught my eye this week.

Sorry guys, I am up against it this evening so no devastating hot take preamble from me today.

As ever though, thoughtful responses on the articles featured this week are more than welcome in the comments.

Have a great weekend!

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Some Monevator readers question why they should bother owning bonds in their portfolio when they can earn higher yields with cash. They make a good point.

A competitive three-year fixed rate savings account bags you a 1.3% interest rate right now. Whup-whup!

Think that’s overenthusiastic? Well, a rate of 1.3% is positively Epicurean compared to the shoeing you can expect for offering your money to the bond market:

• The yield on a three-year gilt is currently -0.1% according to the FT’s Bond Yields table. Robber barons!

• The equivalent short-term gilt ETF will also steal your cash like an identity thief in the night. The SPDR 1-5 Year Gilt ETF is currently tempting punters with a -0.1% yield to maturity (YTM). They might as well offer to set your wallet on fire. Or send you on holiday to a wet market.

• It’s no coincidence that this duration 3 gilt ETF has the same YTM as a three-year individual gilt.

If you compare the duration of any gilt ETF against the same length maturity on the FT’s Bond Yields table, you’ll see that the ETF’s YTM approximately matches the yield shown on the table.

Capiche? A gilt ETF is no more than the sum of its underlying gilts, after all.

That leaves our three-year cash option 1.4% ahead of its gilt equivalents. In cash terms, you’ll earn an extra £1,400 in interest per year for every £100,000 you have tucked away at that interest rate.

Meanwhile, taking on more interest rate risk does not look worth it – even 30-year gilts yield only 0.68%. As carrots go that reward is shaped like a particularly hideous load of old genitals.

And if you’re worried about inflation then the market is saying: “Don’t bother your head.”

What happens if interest rates rise?

Let’s say interest rates rise by 1%. That doesn’t seem likely any decade soon but bear with me.

Your old gilts immediately drop in price. That’s because their scrawny interest rates are forced to compete with the pumped-up coupons of shiny new bonds, which parade around the market like bodybuilders on Venice beach.

Our three-year gilt and short-term gilt ETF would fall about 3% in price to remain attractive to buyers. (As per the duration of 3 mentioned earlier). ((The duration number tells us approximately how much a bond or bond fund will gain or fall in value for every 1% change in interest rates.))

The three-year savings account would also drop its pants by about 3%, if there was an open market in fixed-rate savings bonds. You can instinctively tell that, by imagining how much interest you’d lose if rates rose by 1% the day after you opened the account.

A 24-hour delay would have netted you an extra £1 in interest per £100 saved for the next three years. Whipping out our compound interest microscope we can see:

£107.06 would be ours after saving £100 for three years at 2.3% interest per year –versus a paltry £103.95 in an alternative universe where we only earned 1.3% interest.

103.95 / 107.06 x 100 = 97.1%, or a 2.9% loss if you were condemned to life in that wrong universe.

Pop this battle royale into a duration calculator and you get a duration of 2.9 – confirming the 2.9% loss for the 1% rise in interest rate.

If you’re as anal as I am then you can put the very same particulars into a bond pricing calculator. The value of your £100 drops to £97.13 due to the 1% interest rise. High five! (C’mon, don’t leave me hanging…)

The savings ‘bond’ is essentially the same as the outmoded gilt. You’ll take a 3% loss if you stick with it. Except that on the bond market you’ve already taken that capital loss quicker than you can say, ‘Bond Apocalypse’. Whereas all you need do with the cash is foist the unwanted savings account back on to the bank. It’s like financial wardrobing.

If the switch costs you less than 3% (in this case) then that’s another win for cash over similar maturity gilts.

Suppose that busting out of your savings account incurs a penalty of 180 days interest.

180 / 365 x 100 = 49.3% (the percentage of your interest rate that you’ll lose that year).

0.493 x 1.3 (the account’s annual rate of interest) = 0.64% (loss of interest that year).

You’re paying a 0.64% cost to ditch the savings account versus a 3% loss on the gilts.

This calculator shows you the interest rate you’ll actually get on a fixed rate savings account if you take an early withdrawal charge.

And this early withdrawal calculator from the excellent Finance Buff goes a stage further if you can’t decide whether to stay or go.

The comparison between cash and gilt losses only worsens as maturities lengthen. If you’re the Nostradamus of interest rate forecasts then you know what to do…

Bonds in a crisis

Where gilts tend to excel – especially over the last two decades – is spiking in price when equities are jumping off a cliff.

Coronavirus crash: gilts vs cash vs equities

Source: JustETF.com

The chart shows gilt ETFs peaking in unison on 9 March 2020. The longer their maturity, the higher they surge:

• Long gilts: +11.9% (red line)
• Intermediate gilts: +7.2% (orange line)
• Short gilts: +0.99% (blue line)
• Money market (cash equivalent): +0.03% (yellow line)

When global equities hit bottom on March 23, a 60:40 portfolio (blue line) was in much better shape than a 100% equities portfolio (green line):

60:40 Global equities : Money market (cash)

The 60:40 portfolio was down 16% while equities face-planted -26%. Of course, -16% isn’t great, but you can see the ride is gentler and that can make the difference between panicking and holding on.

60:40 Global equities : Intermediate gilts

The 60:40 intermediate gilt portfolio performed better than its cash cousin but not by much.

At the height of the crisis, this portfolio was down 14%. I was very glad I held gilts on 23 March but I doubt I’d have freaked out at -16% either. With that said, everybody has a tipping point…

Still, this is only one data point. Intermediate gilts did much better during the Global Financial Crisis when they rose 19% while global equities tanked -38%.

You could argue that the spike in gilts gives you more firepower when you rebalance. That’s true, although many studies have shown the rebalancing bonus to be small to non-existent. You also have to actually be able to rebalance into the teeth of the storm.

It’s worth noting that if your cash is in variable rate accounts then yields will most likely tumble during a recession (witness the rate slashing of the last few months). Your gilts can still make capital gains, which may be usefully rebalanced when you regain your poise.

Avoid binary thinking

It’s easy to forget in our polarised age that there is an alternative to ‘For’ versus ‘Against’.

Do we have to choose cash or bonds? The very point of diversification is that we place our chips on both.

120 years of UK asset returns shows that you were better off holding some cash in your portfolio 62% of the time when equities scored an annual loss. (Although cash has taken a beating every year since 2008 versus gilts and equities).

History also tells us that cash has been nothing but a drag on sustainable withdrawal rates if you want your retirement portfolio to last longer than 25 years.

I’m not attracted to this time is different theories but we are living through strange times. As yields fall below zero, cash and short-term gilts act like clapped out O-rings and lose their ability to contain losses. But long bonds (a proportion of which are held in intermediate gilt funds) can still make huge countervailing gains in sub-zero conditions.

It’s interest rate risk that looms largest in most people’s minds when they think about bonds, though. I know I didn’t want it holding me back when I first started investing. As a result, the defensive side of my portfolio was all in cash that doubled up as an emergency fund. Not best practice.

Back in those days I ignored two major risks:

• I had no idea what my risk tolerance really was beyond some vague notion of ‘backing myself’ in a crisis. The reality is I didn’t know how I’d react.

• The second problem is that at some point – without realising it – you’re no longer the devil-may-care desperado of old. You wake up one day with something to lose, but you never pass a road sign saying: ‘You’ve Made It. Caution Ahead.’

Without a plan to ease off the brakes, there’s every chance you could careen off the road during a future pile-up.

To that end, government bonds still provide the best stopping power you can buy.

And I’ll keep making room in my portfolio for gilts and cash because, well, diversification.

Take it steady,

The Accumulator

Bonus appendix: miscellaneous ‘cash vs bonds’ tie-breakers

Protection

As everyone in the UK is aware since that incident with Northern Rock, banks can go bust. Up to £85,000 worth of your cash is protected per ‘authorised institution’ thanks to the FSCS compensation scheme.

That sounds pretty sweet until you find out that 100% of your readies are protected when you hand them over to the British Government in exchange for an IOU – aka a gilt. Her Majesty’s Treasury will definitely pay you back. ((Although they do reserve the right to inflate away the national debt like a Chinese Sky Lantern if things ever get a bit much.))

That in turn sounds pretty sweet until you check out the investor compensation scheme and realise that your 100% protected gilt holdings could disappear in a puff of mismanagement if your fund or platform provider went down in mysterious circumstances.

Then you’re back to £85,000 compensation, or less if the FSCS scheme turns out not to apply. A disaster like this is not likely but it could happen and it casts new shade on the whole ‘backstopped by the UK’ promise.

The sweet spot is cash parked in the National Savings & Investments (NS&I) bank. NS&I savings are guaranteed by the government and there’s no other weak link in the chain forcing me to write several lines of warning.

Better still, NS&I savings products are hot right now especially as the government has a huge hole to plug in the public finances.

Even better than that, you can pop eligible NS&I products into your SIPP. Although it looks like only owners of expensive ‘full’ SIPPs and SSAS vehicles need apply. ‘Simple’ SIPPs – as offered by most platforms – don’t look like they co-operate.

But I’m not expecting NS&I index-linked certificates to come back any time soon. These amazing inflation shields – perfectly tailored for the little guy – are subject to a value-for-money test by the Treasury. That pits them against the cost to the public purse of raising funds in the wholesale markets using equivalent gilts.

As the government has been able to issue index-linked ((That is, a return that keeps the value of your investment unchanged in real terms after a particular measure of inflation.)) gilts at negative real yields for several years, I don’t think they’re likely to come to the likes of you and me for a few billion, even if we agreed to an interest rate of CPI +0%.

Taxes and other cost considerations

Cash in a savings account doesn’t incur dealing fees or OCF charges but that’s neither here nor there when you’re making strategic asset allocation decisions. Most passive investors can hold gilt index trackers extremely cheaply.

Individual gilts are not liable to capital gains whereas gilt funds are.

Interest paid by bonds and bond funds benefits from your tax-exempt Personal Savings Allowance and Starting Rate for Savings, just as cash does.

What caught my eye this week.

I have mentioned before my group of friends on an email list who’ve been debating Covid-19 since January.

Well, this same group of friends was previously preoccupied by arguing the future of cash.

I think cash use is doomed to dwindle in the West, probably fast. Most of them think that would be terrible.

Now it seems the streams are crossing. It’s becoming clear from the data that cash use has crashed in the Covid-19 era and the knock-on lockdown.

You can’t touch this

I have shares in a bunch of listed and unlisted fintechs and payment companies that have seen their prospects skyrocket since physically touching anything except a bar of soap became oh so 2019.

Some are seeing higher volumes, such as the automated savings app Chip.

Others are taking a short-term hit to their ‘take’ because overall spending is down – but they are seeing more users turn to their products, which bodes very well for the future. Square and Visa are examples here.

The trend is their friend. Just this week I received another press release suggesting UK consumers are increasingly shunning cash.

The release – from a technology and branding company called Toluna – states:

• The use of ATMs has reduced by 36% during the pandemic, mostly because of people not being out and about much but also the [perceived] higher transmission risk of the virus when handling cash.

• Online banking or use of mobile apps and payment methods has increased by 33%.

• Phone banking is down by 5%.

• Those visiting their bank in person is also a lot less now than it was before the pandemic, with branch banking experiencing a 34% decrease.

Rather like the feasibility of working from home seems to have astonished half of UK PLC, the infrastructure for the cashless society was already pretty much in place before many people decided to finally try it.

Fintech to the rescue

I agree with my friends that some marginalized – particularly elderly – communities may not be super-comfortable using the latest fintech app to monitor their finances, or to wave their mobile phone to buy a pint of milk.

But where I disagree is the claim that this is an insurmountable problem.

A determined effort by the government and the private sector could create some kind of universal digital option for those still living pre-2005.

Just a State-issued contactless card and monthly paper statements in the post would do in a pinch.

But of course I’d rather everyone got more ambitious. Because where I really disagree with my friends is when they claim that ditching cash is disempowering from a budgeting perspective.

The power of apps like Money Dashboard ((Affiliate link, sort of. If you register I get ten free ‘member shares’ worth about 60p at the last count.)) leaves counting out coins from a jam jar in the dust.

Indeed even the most humdrum mobile bank accounts are beginning to boast features that were the cutting-edge from whizzy start-ups in East London just a few years ago.

Three valid fears

I do agree with my chums in three respects, however.

Firstly, the cashless digital society is in need of a back-up plan when, metaphorically, the battery runs out.

This could be because I forgot to charge my phone or because a financial service provider is hacked, crashed, or forgot to charge its phones (/servers).

I can think of various ways around this – solutions using biometrics, cryptocurrencies, and short-term (invisible?) peer-to-peer lending.

But until they exist, the case for keeping a wodge of tenners as an option is strong.

Secondly, digital payments are far more friction-free. And it’s true this could encourage more thoughtless spending. However that’s nothing new. We’ve had credit cards for decades. As I say, at least with digital payments you have the potential to build in all kinds of automated checks and balances that you can’t do with dumb cash.

Finally, to lose the cash option is definitely to lose some privacy.

Perhaps that will be the edge case that finally leads to a Bitcoin usage explosion? Not for buying illicit drugs on an Internet backwater, but for paying for more humdrum items that you’d still rather a spouse or the government didn’t see.

Noted

I’ve come around to the view that Covid-19 is going to change more than seemed likely six months ago.

Encouraging the demise of cash is near the top of that list, I reckon.

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