Cash vs. Bonds: How Interest Rates Change the Game

NEW YORK (MainStreet) -- Fixed-income investors are in a classic lose-lose situation: Put your money in cash and you’ll be safe but earn almost nothing. Put it in bonds and you’ll earn a bit more, but probably not enough to offset loss of principal if interest rates rise.

As we’ve been saying for a while, interest rates are so low right now they’re more likely to rise than to fall even further. Higher rates on new bonds make older, stingier bonds less attractive, causing their prices to fall. That leaves the bond investor an unpleasant choice: sell at a loss or keep the bond and continue to receive substandard yield until the bond matures and your principal is repaid at face value.

You can avoid all this by shifting to cash, though the low yields might give you some sleepless nights.

The bonds-vs.-cash decision is a classic struggle between risk and reward. To shed light on the issue, Christine Benz of Morningstar, Inc., the market-data firm, has recently revisited her earlier explanation for how to stress-test a bond holding, drawing on work by Ken Volpert, head of the taxable bond group at Vanguard, the mutual fund giant.

The analysis is worth another look now as investors sort conflicting signals: jittery financial markets that threaten to push rates up, working against the Federal Reserve’s vow to keep them low.

The process begins with duration, a measure of volatility in bonds and bond funds. Duration, which is found on a bond fund’s website, is measured in years. A duration of 5 years, for example, means that the bond fund would lose 5% of its value for every percentage-point increase in prevailing interest rates. That means 10% for every two-point rise, or a 10% gain in value for every two-point decline.

But duration is just part of the story, because the investor may choose to continue owning the fund even after the share price falls. In that case the loss in principal would be partially offset by interest earnings.

So Volpert’s approach is to subtract the fund’s yield from its duration. He recommends using the SEC yield figure, which is also usually on a fund’s website. The result shows how much the investor would lose after 12 months. There could, of course, be a gain if the yield was healthy and the duration was very short or the interest increase very small.

In Benz’s example, the Vanguard Total Bond Market Index fund has a duration of 5.1 years and yields 2.23%. That means every one-point rise in interest rates would cost the investor about 2.9%. By subtracting the yield from the duration, the investor would get a better sense of the risk and reward of keeping money in bonds instead of moving to the safety, but low returns, of cash.

Keep in mind, though, that the duration-minus-yield calculation only reveals losses during the following 12 months. In the example above, the investor would lose 2.9% during that period, but then earn 2.23% in the following year, assuming that were still the fund’s SEC yield.

Of course, that assumption is not guaranteed. If rates were to rise, the fund’s yield would gradually rise as well as old bonds in its portfolio were replaced with new ones.

Interest rates affect fund traders every day, but plenty of investors use money funds to plan for their retirement. Check out our look at 7 Funds to Rebuild Your Nest Egg for 2012 for tips on where to put your money!