While holding onto cash, whether you do it physically or by putting in a bank account, has some real advantages, bonds can also be a good place to park your money. While you may give up some liquidity and take additional risk, bonds offer higher returns than cash. On the other hand, some short-term bonds act like a hybrid between the two asset types, offering enhanced liquidity and risk protection in exchange for lower returns.
Cash held as cash has no return. If you put $10,000 in a safe and go back to it in 20 years, you'll still have $20,000. When you put it into a cash-equivalent bank account like an interest-bearing checking or money market account, you'll earn a return, but it will typically be low relative to other investment vehicles. Bonds, on the other hand, offer the opportunity to earn a range of different returns. While high-quality short-term bonds have returns that are close to those of a bank account, long-term bonds and those with slightly riskier issuers can offer returns that approach or exceed what you can get in the stock market.
There is essentially nothing more liquid than cash, whether it's in a safe or in a bank account with no withdrawal restrictions. Bonds are also usually liquid through secondary market trading, but buying and selling bonds typically involves paying commissions or fees, which means that you incur a cost for accessing your cash. You also take a slight risk that there won't be a buyer for your bond. One way around the challenges of the secondary market is to purchase short-term bonds directly and hold them to maturity.
Risk to Principal
Holding physical cash puts you at the risk of having the money stolen or physically destroyed. When you put money in a bank, it's protected up to the bank's insurance limit. As long as the bank's insurer, which is usually the Federal Deposit Insurance Corporation, pays off, you won't lose your money. With bonds, you have two different risks. The first is that the value of the bond could drop, reducing the value of your principal. The second is that the bond's issuer could go bankrupt and not pay you back at all.
Inflation and Interest Risk
Both cash and most bonds expose you to inflation risk: $10,000 in principal left in a vault, in a bank account or in a bond probably won't have $10,000 worth of purchasing power in 20 years. When you use an interest-bearing vehicle, like a bond or bank account, the interest you receive can balance out some or all of the inflation. Bonds are also subject to interest rate risk. When interest rates go up, existing bond values drop, because they don't pay as much interest as newer bonds. Selling them at a lower price helps to compensate for their lower, fixed interest rates. Generally, the longer a bond's term is, the more the price drops, as the lower rate will cost you more over time.
Bond Cash Equivalents
Some bonds are actually considered cash equivalents. When you have a bond or bond fund that can be easily turned into cash and doesn't fluctuate in value that much, accountants call it a cash equivalent. Some examples of cash equivalent bonds include three-month or shorter Treasuries. Commercial paper, which is a short-term debt security issued by a company, can also be a cash equivalent when it's issued by a large company with a high credit rating. Funds that hold these types of bonds and try to prevent their prices from fluctuating, like money market funds, are also considered cash equivalents.
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