When should Cash supersede Bonds?

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Portfolio7
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When should Cash supersede Bonds?

Post by Portfolio7 » Mon Oct 31, 2016 3:30 pm

DW and I are late 40's, we carry a 72% Equity / 28% Bond portfolio in our 401Ks.

I'm happy with our portfolio, and will slowly be shifting more to bonds when I hit 50. The question I have, is when should cash supersede bonds, and to what extent? Certainly in retirement, I am likely to want 3-5 years cash on hand, but until then....

My philosophy is that bonds are supposed to be a low-risk diversifier. I'm 80% Int Treasuries and 20% Tips, because Treasuries historically have a significant negative correlation to the rest of my portfolio. I feel like I need those bonds, given the 72% of my portfolio that is in equities. I don't feel like I need 'gunpowder' when markets are volatile, I just rebalance behind the tax wall (most of my savings are tax-advantaged).

However, I can invest in a stable value fund, which I regard as cash, and exceed bond yields by 1.5% or so. I'm not yet inclined to do that, but I'm struggling with whether it would ever make sense, or do I just close the book on cash for now? The bonds have great value in that they pretty effectively increase when equities decrease, even if the timing is slightly delayed as it often is. Cash doesn't do that. I'm not sure if looking at it in 'real' terms (excluding inflation) would provide different insights? Is there additional value to cash that I'm overlooking?
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mhc
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Re: When should Cash supersede Bonds?

Post by mhc » Mon Oct 31, 2016 3:43 pm

Only time I would hold cash over bonds is if I could earn more with the cash with a similar risk as the bonds.

I do not ever plan to hold 3-5 years worth of cash. It is just throwing away money for a false sense of security. YMMV.

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Re: When should Cash supersede Bonds?

Post by Dandy » Mon Oct 31, 2016 3:57 pm

I don't think there is a firm answer. I really liked the Stable Value fund when I was in the accumulation stage. I no longer have access to it in retirement.

I favor a mix of fixed income and would surely have a decent allocation to a relatively safe Stable Value fund since it is not very impacted by changes in interest rates, economic growth etc. I now use CDs instead of a Stable Value. I have 1/3 of my fixed income in "no loss of principal (e.g. CDs, money markets, etc.), 1/3 is short term bond funds, and 1/3 in intermediate bond funds (including TIPS). That fits my asset preservation goal.

Since you are still in the accumulation and most likely growth mode you might have 1/3 Intermediate Treasuries, 1/3 TiPS, and 1/3 Stable Value.
I like the Treasury investment but think that while they may be great when there is a flight to quality they might be a bit overvalued since US interest rates are luring foreign investors since they safe yield is hard to beat. So, they may take a bit of a hit should foreign negative interest rates turn positive. A bit more diversification might be in order. But not critical.

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Re: When should Cash supersede Bonds?

Post by Fclevz » Mon Oct 31, 2016 4:00 pm

Portfolio7 wrote:...I can invest in a stable value fund...and exceed bond yields by 1.5% or so.
^^^ That's when.
Higher yield with a lower duration seems like a no-brainer, unless you are expecting a big capital-gain opportunity from falling bond yields.

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Re: When should Cash supersede Bonds?

Post by dabblingeconomist » Mon Oct 31, 2016 4:05 pm

Fclevz wrote:
Portfolio7 wrote:...I can invest in a stable value fund...and exceed bond yields by 1.5% or so.
^^^ That's when.
Higher yield with a lower duration seems like a no-brainer, unless you are expecting a big capital-gain opportunity from falling bond yields.
Even people without access to a stable value fund can get higher yield, conditional on duration, outside of the bond market.

Savings account rates at high-yield online banks are higher than short-term T-bill yields, and CD rates out to 5 years or so are as high or higher than medium-term Treasury yields - with equivalent security assuming you're under the FDIC cap.

People are often fooled by the upward-sloping yield curve into thinking that bond yields beat online bank rates, since they'll look at (say) an intermediate-term bond fund and compare it to a savings account, not realizing that the former has duration of 5 years and the latter of 0 years. If you compare apples-to-apples, bonds really aren't that great.

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Re: When should Cash supersede Bonds?

Post by Taylor Larimore » Mon Oct 31, 2016 4:15 pm

When should Cash supersede Bonds?
Portfolio7:

In my opinion, cash and good-quality short- and intermediate-term bond funds are almost interchangeable. Both provide safety and income in a portfolio. There is no "free lunch."

Cash and bonds are for safety; stocks are best for higher return. If you decide on super-safe cash it allows you to increase your stock allocation. If you decided on bonds with their higher risk, you should cut back on your stock allocation for the same expected risk and return.

Best wishes.
Taylor
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Re: When should Cash supersede Bonds?

Post by Portfolio7 » Tue Nov 01, 2016 12:25 am

Thanks all for great food for thought. MHC, that's what I would have said a few months ago, but I keep wandering back to challenge that assumption.

Fclevz and Dabbling Economist, I'm used to thinking of bonds as something that tend to have big gains during a market drop and so are very helpful for a portfolio, in a way cash isn't. However your thoughts help me see that in a bit of a new light.

Taylor, you kind of put the bigger picture together - as an investor (22 years) I only know the bond bull market, and had never really thought of cash as a legitimate portfolio component, certainly not as a catalyst for higher equity skews - funny how you can read certain things several times and think you understand, until a new consideration leads you to a better understanding of their meaning.... I ran my portfolio on Portfolio Visualizer, and replaced bonds with cash, and found it did just a tad better in the 1970's and close in the 1980's. This is not something I expected to see at all, though I'm aware that bonds have struggled for extended periods in the past.

Dandy, I really always thought of diversification as an Equity thing, once you decided on your equity/bond split... the bond portion was for safety, and the greatest safety was achieved by the asset that did best when equities did poorly. However, diversification into cash is looking like a reasonable strategy given current relative yields, so I'm beginning to see the value in at least a small step into cash.

Thanks to everyone for your thoughts, and the primer on how to think of cash!
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Re: When should Cash supersede Bonds?

Post by stlutz » Tue Nov 01, 2016 12:53 am

However, I can invest in a stable value fund, which I regard as cash, and exceed bond yields by 1.5% or so
Vanguard's IT Treasury fund yields 1.3%. Are you saying your stable value fund yields 2.8%? If so, it seems like they may be taking more risk there than is immediately apparent.

A stable value fund is usually stable, but it doesn't come with an FDIC guarantee, so it's not like a CD. Do your due diligence on the underlying portfolio.

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Re: When should Cash supersede Bonds?

Post by SpaceCowboy » Tue Nov 01, 2016 2:36 pm

stlutz wrote:
However, I can invest in a stable value fund, which I regard as cash, and exceed bond yields by 1.5% or so
Vanguard's IT Treasury fund yields 1.3%. Are you saying your stable value fund yields 2.8%? If so, it seems like they may be taking more risk there than is immediately apparent.

A stable value fund is usually stable, but it doesn't come with an FDIC guarantee, so it's not like a CD. Do your due diligence on the underlying portfolio.
While stable value is not FDIC insured but backed by an insurance company, I'm not aware of a SVF busting the buck even in the 2008 crisis. If I had access to a SVF yielding over 2.5%, I'd be all over it for my FI allocation in the current low rate environment.

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Re: When should Cash supersede Bonds?

Post by Portfolio7 » Tue Nov 01, 2016 4:57 pm

So, the SV fund is returning about 2.9%. I had some of my portfolio allocated to this fund in 2007/8/9 and it held up just fine.

Description is: The fund may invest in wrapped bonds, a limited amount of unwrapped bonds, cash, and U.S. government Series I savings bonds. For the wrapped bonds, the fund invests in insurance contracts ("wrap contracts") which allow the portfolio to earn a specified rate of interest that may be more or less than the actual income earned by the fixed income securities. Unit price, yield and return will vary.

There is no additional information about specific underlying investments.
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Re: When should Cash supersede Bonds?

Post by Kevin M » Tue Nov 01, 2016 5:46 pm

Portfolio7 wrote: My philosophy is that bonds are supposed to be a low-risk diversifier. I'm 80% Int Treasuries and 20% Tips, because Treasuries historically have a significant negative correlation to the rest of my portfolio.
Although this has been true in recent years (for nominal Treasuries, not TIPS, which dropped in 2008), the long-term correlation of bonds to stocks is about 0%, which is the same as cash. Also, for the 15 years from 1967 - 1981 (inclusive), the real, cumulative return of intermediate-term Treasuries was about -34% (that's a negative number) while the cumulative real return of stocks was about -3%, and short-term Treasuries was about -15%. Of course this was before TIPS existed.

So if you want to hold some int-term nominal Treasuries for a potential rebalancing rebonus, or as a hedge against deflation, that's fine, but don't expect Treasuries to always bail you out when stocks tank. It's easy to envision a rising rate scenario in which both do poorly.
Portfolio7 wrote: However, I can invest in a stable value fund, which I regard as cash, and exceed bond yields by 1.5% or so.
I would definitely use this fund for a big chunk if not all of my fixed income in a 401k. You are getting a much higher yield with essentially no term risk, and based on history at least, minimal credit risk. The higher yield with no term risk provides a decent inflation hedge, as short-term nominal rates (and probably SV fund rates) tend to rise with inflation, and you can roll over your Treasuries to the higher rates as they mature (which is why short-term Treasuries lost less than intermediate-term Treasuries in the 1967s-1981 period).

Not having access to a good SV fund like you do, I use direct CDs for the majority of my fixed income, with yields that have been on average more than a percentage point higher than Treasuries of same maturity over the last six years. That extra yield accumulates over the years to more than make up for any rebalancing bonus you get from Treasuries in flight to safety scenarios.

Kevin
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Re: When should Cash supersede Bonds?

Post by Portfolio7 » Tue Nov 01, 2016 6:51 pm

Thanks Kevin! Swedroe seems to suggest that liquidity issues may be responsible for TIPS 2008 performance (issues that won't repeat).. regardless, I appreciate your data on periods of poor bond returns. I have a lot of thinking to do about how much to modify my portfolio, especially since I find your points very convincing when considered in light of all the other comments. Data can only yield so much, but "logic" can run pretty far astray, as it's so easily misapplied. I have a policy of moving slowly, no more than 10% a month when I decide to adjust my mix.... yet it feels very reasonable to add a significant stable value allocation to the mix while I consider further. Appreciate the input!
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Post by Taylor Larimore » Tue Nov 01, 2016 7:31 pm

I have a lot of thinking to do about how much to modify my portfolio,
Portfolio7:

If you like to think about modifying your portfolio, read this:

INVESTING IN TOTAL MARKETS by John Norstad

Best wishes.
Taylor
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Re: When should Cash supersede Bonds?

Post by Portfolio7 » Tue Nov 01, 2016 11:11 pm

Thanks Taylor, I love to read about portfolio construction. I think EMH and the CAPM framework are incredibly valuable tools, yet I've not come to quite the same conclusions presented in that article (yet?), though I have at least a passing familiarity with most of the topics broached by JN. While I'm sure I have many flaws in my thinking (and I love these discussions for that very reason, as they force me to identify and explore the many possible weaknesses in my investing beliefs), I don't believe markets are efficient any more than I believe that a demand supply curve representing frictionless economies with perfect information describes anything that actually exists. I have to be candid that I believe all markets are imperfect, and there are a lot of good reasons for them to be so. Capital/Bond markets come about as close as any market to being efficient... but there are many more markets of varying levels of efficiency, and which of these should we invest in? Bernstein seems to dismiss many asset classes as unworthy of investment in TIAA, and I tend to think I agree with that. It therefore follows that I question the efficient frontier model, though I believe the concept to be instructive and highly relevant. (I also think that risk is under-appreciated by many as 'the' core element of portfolio design.)

I also realize, to paraphrase 'Cool Runnings' that you & JN are coming from Multiple Nobel Prize-winning research, a lot of really smart people using really complicated math, and if you accept the initial theoretical underpinnings, an incredibly logical conclusion, which is a heck of a place to be coming from(!) One reason I asked the question to start this thread is that despite thinking what I do, I try to always be learning.... I think the height of wisdom is to realize how little one really knows. Your comments and the link (which I've printed to include in my notes) are very much appreciated, thanks!
"An investment in knowledge pays the best interest" - Benjamin Franklin

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Re: When should Cash supersede Bonds?

Post by jebmke » Tue Nov 01, 2016 11:21 pm

The only time we carried any significant cash was when I was an ex-pat and there were wild swings in cash flow due to the way the ex-pat tax program worked (as well as very small CC credit limits). Once I retired and we moved back to the US I eliminated cash except for what we need at the beginning of the month to pay bills. Cash is a real drag on returns so it doesn't pay to hold it as an investment. I view it as working capital. Bond funds are plenty liquid and have produced higher returns than cash.
When you discover that you are riding a dead horse, the best strategy is to dismount.

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Re: When should Cash supersede Bonds?

Post by patrick » Wed Nov 02, 2016 12:56 am

rrppve wrote:While stable value is not FDIC insured but backed by an insurance company, I'm not aware of a SVF busting the buck even in the 2008 crisis. If I had access to a SVF yielding over 2.5%, I'd be all over it for my FI allocation in the current low rate environment.
SVF losses have happened according to this article: http://www.kiplinger.com/article/invest ... times.html (look under "First victim")

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Re: When should Cash supersede Bonds?

Post by SpaceCowboy » Wed Nov 02, 2016 10:39 am

patrick wrote:
rrppve wrote:While stable value is not FDIC insured but backed by an insurance company, I'm not aware of a SVF busting the buck even in the 2008 crisis. If I had access to a SVF yielding over 2.5%, I'd be all over it for my FI allocation in the current low rate environment.
SVF losses have happened according to this article: http://www.kiplinger.com/article/invest ... times.html (look under "First victim")
No they actually did fine. Per the article, Lehman Brothers own SVF had a one month loss, but was still positive over the year. Also, at the time the SVF was not 100% insured, which is unusual. The other example was Chrysler's, but this was in a deferred compensation plan which by definition is treated as a general creditor of the Company in bankruptcy and not a protected employee benefit under ERISA.
Thus, I still believe SVF in 401(k)s are very safe. Yes Lehman's temporarily broke the buck, but only for a month and it was temporary.

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