To describe the bond market as large is an understatement. The Securities Industry and Financial Markets Association (SIFMA) tabulates close to $52 trillion worth of outstanding fixed-income securities in the U.S. as of the end of first-quarter 2021.

Though comparatively smaller, allocations to cash-like instruments are also large at the aggregate level. SIFMA says there is more than $1.1 trillion of outstanding money market funds and very short-term securities.

Both bonds and cash-like instruments can play an important role in an investor’s portfolio. In this article, we address both bonds and cash-like instruments [money market funds, certificates of deposit (CDs), etc.] from the standpoint of Step 4 of the PRISM Wealth-Building

Process—selecting and managing your investments (Figure 1). We share some of the key characteristics to look at when analyzing bonds, discuss the choice between bonds and bond funds, explain the role of laddering and provide a basic framework for choosing among cash-like instruments.

Investors interested in a more detailed discussion about funds should read “Guidelines for Selecting Mutual Funds and ETFs” in the July 2021 AAII Journal. Stocks were covered in the August 2021 AAII Journal (“Guidelines for Selecting Stocks for Your Portfolio”).

Allocation and Withdrawal Needs Determine the Role of Bonds and Cash

Bonds reduce the level of volatility of a portfolio’s return. They also provide a stream of income. Cash preserves nominal wealth but does a poor job of protecting a portfolio against the eroding effects of inflation.

Beyond cash savings to cover emergencies—something every investor should have—the decision to hold bonds and cash-like instruments depends on your allocation and withdrawal needs. This viewpoint stems from the top-down approach used by PRISM. We believe an investor’s allocation should reflect their goals and risk tolerance, not tactical choices such as expectations about where interest rates may be headed in the future.

In addition, preferences, needs and constraints should be factored in. Some investors prefer to maintain a certain allocation to cash-like instruments to take advantage of downturns in the stock market or to provide a bucket from which portfolio withdrawals can be taken. A variety of personal situations can necessitate an allocation to cash-like instruments.

Example: Retired Couple With a Pension

Jane and Bob are married and recently retired. They are fortunate to have their living expenses covered by pension and Social Security benefits. This allows them to focus on their secondary goals of helping to pay college expenses for their two grandchildren, who are both young.

Because the couple’s guaranteed sources of income are large enough to cover their spending needs, they can maintain an aggressive allocation. This means having a small allocation to bonds and cash-like instruments beyond what should be set aside for emergency spending and splurges (e.g., a very nice vacation).

Still, Bob and Jane face two potential constraints that could influence their allocation preferences.

The first is required minimum distributions (RMDs) from their traditional IRAs [and 401(k) plan account, were either to have one]. If their broker allows in-kind IRA distributions, they would be able to transfer shares of stock directly to a taxable account. (In-kind distributions from a traditional IRA are taxed at ordinary income rates like cash withdrawals are.) If either of them takes a cash distribution, they will have to decide whether to maintain a cash allocation to fund the withdrawals or to sell a portion of investments to fund each withdrawal.

In either case, maintaining some allocation to bonds would allow them to better withstand volatility in their equity holdings from a psychological perspective.

The second constraint is the grandchildren’s college expenses. Planned annual contributions to 529 plans would necessitate the need to maintain an allocation to lower-risk investments. If the couple opted for lump-sum gifts at the time college expenses are incurred, a more aggressive allocation could be maintained. The potential impacts of financial aid should be a consideration when deciding which option to follow. Nonetheless, it shows that funding secondary goals can influence the decision of how much to allocate to bonds or cash-like instruments.

Key Characteristics of Bonds

There are three types of characteristics to consider when choosing bonds and bond funds. They are maturity, credit quality and bond type.

Bond Maturity Determines Interest Rate Sensitivity

One characteristic of bonds is maturity. Bonds are debt instruments with a set date for when the loan must be paid back to investors. The farther out into the future this maturity date is, the more sensitive the bond will be to changes in interest rates (Table 1).

Fixed interest rates are the reason why. The interest rate for traditional bonds is set at issuance. The longer the time until the bond’s principal (the amount of the loan—typically $1,000 for a bond issued in the U.S.) is paid back, the longer an investor will be locked into the interest rate.

A bond paying a 4% coupon is more attractive during periods when prevailing rates on newly issued bonds with similar maturities have 3% coupons. Should interest rates rise to 5%, the 4% coupon bond will seem less attractive. Investors will not mind the difference as much if their 4% coupon bond was going to mature in a year or two as much as they would mind if the 4% coupon bond was not going to mature for another 15 or 20 years.

Interest rate changes alter a bond’s price and yield. Yield is income received divided by the price paid for the bond. Since the level of income is fixed with bonds, bond prices are adjusted based on prevailing interest rates. Falling rates reduce yield (higher prices are paid for bonds with larger relative coupons) while rising rates raise yield (lower prices are paid for bonds with smaller relative coupons).

How sensitive a bond is to changes in interest rates can be determined by looking at its duration. Measured in years, duration shows how much a bond’s price can be anticipated to move if interest rates move by 1%. A duration of five years means a 1% move in interest rates should lead to a 5% change in the bond’s price. Bond funds report duration for their portfolios.

The relationship of each year of duration equaling a full-percentage-point increase in interest rate sensitivity is not an exact measure. Bond prices are convex, with falling interest rates leading to comparatively larger price increases and rising interest rates leading to comparatively smaller price decreases. Nonetheless, duration is a useful tool for setting expectations about future price volatility.

The AAII Asset Allocation Models use both short-term and intermediate-term bonds. Short-term bonds are generally those maturing in one to five years. Intermediate-term bonds mature in five to 10 years. Long-term bonds have longer maturities. Their extra yield may not be comparatively high enough to offset their higher interest rate risk, though laddering can be used to minimize some of these risks.

Credit Quality Adjusts Yield for the Risk of Default

Another big influencer on yield is credit quality. Credit quality is the perceived ability of a bond issuer to service their debt. The riskier a bond issuer is perceived as being, the higher the yield bond investors will demand in return.

Credit quality is of key importance because the return of a bond is fixed if it is held until maturity. At purchase, the interest rate, the yield and the maturity date are all known. This means bonds have limited upside for price appreciation while their downside is a potential complete loss if the issuer goes bankrupt.

Credit ratings fall into one of two broad categories: Investment grade and non-investment grade (Table 2). Investment-grade bonds have a lower risk of default. They are rated between AAA/Aaa to BBB/Baa. Non-investment- grade bonds range between a high risk of default to being in default. Non-investment grades range from BB/Ba to D (C for Moody’s).

Investors seeking to hold bonds in order to counterbalance the risk of equities and/or to provide a source of income would be prudent to consider investment-grade bonds. Similarly, mutual funds and exchange-traded funds (ETFs) that mostly allocate to investment-grade bonds are more suitable for these objectives.

Non-investment-grade bonds and funds are speculative and should be treated as such. Though their yields are higher, so are their price volatility and credit risk. Issuers of so-called high-yield bonds may struggle during economic downturns—the same time investors would want the bond portion of their portfolios to provide a ballast against corrections and bear markets in stocks.

Bond Types and Taxes

Beyond maturity and credit quality, bond investors must also choose a bond type. There are three key types: government, municipal and corporate.

Government Bonds

Government bonds are primarily those issued by a nation’s government. In the U.S., these are most commonly Treasuries. U.S. Treasury bonds are considered to be the safest from the standpoint of credit risk. Yields are lower for these bonds as a result. Interest from Treasury bonds is taxable at the federal level but is exempt from state and local taxes (Table 3).

Bonds issued from government-backed agencies also fall under the government category. The tax treatment for other domestic government bonds can differ from Treasuries. Read the prospectus and consult a tax professional if you still have questions.

Foreign governments also issue their own bonds. Buying bonds issued by other countries incurs currency risk as well as potentially higher costs. Both can diminish returns.

Municipal Bonds

Municipal (“muni”) bonds are issued by state, county and local governments and agencies. Their big allure is the favorable tax treatment. Interest from muni bonds is generally exempt from state, local and federal income taxes. (Read the prospectus to be sure.) The higher your tax rate, the bigger the tax benefit you will receive.

The favorable tax treatment has two implications. First, the yield of a muni bond needs to be compared against the taxable-equivalent yield (aka aftertax yield) of a taxable bond yield. The tax-equivalent yield is calculated by dividing the tax-exempt yield by 1.00 minus your marginal federal income tax rate (in decimal form). This calculation is necessary because muni bonds often have a comparatively lower quoted yield than bonds with less favorable tax treatment.

Secondly, muni bonds should be held in taxable accounts. The preferential tax treatment of the interest payments is lost when a tax-preferred account such as an IRA or a Roth IRA is used.

Retirees should take Social Security and Medicare into consideration when looking at muni bonds. Interest from muni bonds is included in provisional income, which determines how much of Social Security benefits are taxed, and in the calculation of modified adjusted gross income (MAGI), which determines what Medicare Part B premiums will be charged.

Corporate Bonds

Corporate bonds, as the name implies, are debt issued by businesses.

Interest on these bonds is taxable at the federal, state and local (if local taxes are assessed) levels. The interest is taxed at ordinary tax rates. This tax treatment can make corporate bonds and funds that invest in them more suitable for tax-preferred accounts like IRAs.

Credit quality varies widely and is a key consideration. Large, well-known corporations tend to have more favorable credit ratings, but this is not universally the case. Moody’s assigns an Aa1 long-term rating to Apple Inc. (AAPL) but a Baa2 rating to Boeing Co. (BA). The latter rating is essentially at the bottom of Moody’s investment-grade scale.

Economic disruptions and changes in industry conditions can cause corporations to see their credit quality deteriorate. On the other hand, corporate bonds do generally command higher yields and have generally realized higher returns—even among those with higher credit quality ratings.

Choosing Between Bonds and Bond Funds

Purchasing individual bonds is different than purchasing individual stocks. A single issuer can have many bonds issued, each with a different CUSIP. A CUSIP is the identifying number assigned to each bond issue. This means buyers have to not only decide which issuer’s bonds they want to buy but also which specific bond they want to purchase.

A big advantage of buying individual bonds is the ability to create a bond ladder. A bond ladder reduces interest rate risk by holding bonds of different maturities. As shorter-term bonds mature, the proceeds can either be used as a source of cash flow or be reinvested into longer-dated bonds at prevailing interest rates. The increased certainty over cash flows can be helpful for those with projected spending needs at future intervals.

Individual bonds are priced at par ($1,000) or at a premium or discount to par value. They can be sold in lots worth $100,000 or more. While it is very easy to buy a few shares of stock, it is harder to buy just a few bonds at a time. In addition, many bonds do not trade every day. Adding to the complexity is that the brokers embed their commission into the quoted bond price. These factors make it difficult for individual investors with smaller portfolios to hold individual bonds.

One option is TreasuryDirect.gov. Operated by the U.S. Department of the Treasury, it allows individuals to buy Treasuries directly from the government.

Bond mutual funds and exchange-traded funds provide easy access to diversified bond holdings. They can be an effective way for investors with smaller portfolios or smaller bond allocations to get exposure. The trade-offs are expenses, lack of control over the timing of taxable distributions and the reliance on a portfolio manager. In addition, bond ladders cannot be constructed by holding bond mutual funds and ETFs.

A compromise solution is defined-maturity bond funds. Issued by iShares (ETFs), Invesco (ETFs) and Fidelity (mutual funds), these funds mature on a pre-designated date. At maturity, the funds’ balances are returned to shareholders. Defined-maturity bond funds lack the customization afforded by purchasing individual bonds but give investors greater ability to diversify against interest rate risk than is possible with bond funds.

The PRISM Wealth-Building Process calls for embedding a preference for holding individual bonds, traditional bond funds or bond ladders into your rules governing investment selection. The same applies for the choice of bond type, maturity and credit quality. Doing so will provide clarity and allow you to only focus on those investments most suitable to your investing plan.

Cash-Like Investments

Cash-like investments include money market funds, Treasury bills (maturities of one year or less), CDs and savings accounts. Their role in a portfolio is to protect allocated dollars from fluctuations in the capital markets and to make it easy to quickly access those dollars. They do not provide the capital appreciation required to meet long-term goals.

Allocations to cash-like investments should be generally limited to anticipated withdrawals needed within the next approximately two to four years as well as emergency savings. Accounts insured by the Federal Deposit Insurance Corporation (FDIC) provide the most protection, though it is generally rare—but not impossible—for a money market fund issued by a well-established company to go under. Be wary of interest rates that seem too good to be true. They probably are.

Savings accounts, interest-bearing checking accounts and money market funds provide quick access to your money. CDs can offer higher yields and be laddered. The trade-off is a penalty for early redemption. Short-term T-bills can also be laddered, but access to portfolio dollars may not be immediate. The choice of which cash instrument to use comes down to comparative yields, account considerations and how quickly you want to access the dollars. There can be situations where it makes sense to sacrifice yield to keep all accounts with a single or very small number of institutions. 

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