Cash versus bonds: an overview

Cash versus bonds: an overview

With the bull market in the US economy now over 10 years old and with talk of a reversal, many are more concerned with protecting the money they have than growing additional wealth. There are several investment vehicles touted as “safe” places to store savings, but many people feel that nothing could be as safe as cash. The security of knowing exactly where your money is, like keeping it safely in a federally insured checking or savings account, is undoubtedly attractive.

However, with the risk of inflation potentially making today’s dollars significantly less valuable in the future, many low-risk, modest-reward investments continue to be popular with investors looking to put their money to work without incurring too much risk. . Bonds, in particular, have long been heralded as one of the safest investments available, as they guarantee the return of principal while earning regular interest payments.

Holding cash and investing in bonds are viable options for those looking to protect their savings from a volatile market. However, it is important to understand the risk and rewards of both options to ensure you choose the investment strategy that best suits your needs.

Key takeaways

  • Holding cash and investing in bonds are two ways for cautious investors to protect their wealth, even if the economy takes a turn for the worse.
  • Cash is readily available and generally insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000.
  • But cash is sensitive to inflation, and rising interest rates can hurt purchasing power. sitting on cash also means missing out on potentially better investments.
  • Bonds provide investment income with the potential for capital gains if purchased at a discount; There is also the possibility of interest income.
  • On the downside, your bond investment could lose value if the underlying company goes bankrupt or interest rates rise.

Cash

The main benefit of keeping your money in cash is the obvious advantage of maintaining complete control. If you simply deposit your cash into a bank or savings account, you can easily review your balance and transaction history with the click of a button, knowing that no one but you has access to those funds.

Additionally, checking and savings accounts at almost any bank are insured through the Federal Deposit Insurance Corporation (FDIC) for up to $250,000. While banks are not required to purchase this coverage, it has become such a ubiquitous symbol of a bank’s quality that any institution that is not government-insured is unlikely to perform well. Federal and state credit union accounts are also insured up to $250,000 through the National Credit Union Administration (Ncua). Even if your savings exceed this limit, it is possible to secure all of your deposits by opening multiple accounts at different institutions.

Another advantage of holding cash is that it provides maximum flexibility in times of stress. If you need to access your funds shortly, like in the next three years, having cash is the best way to ensure you have the money when you need it. While investing offers profit potential, it can also put your funds at significant risk, meaning you may not have the money you need anytime soon.

Cash risks

The biggest risk you incur when you have cash is the risk of inflation. If interest rates rise, the money you have now may have significantly less purchasing power in the future. This is the main reason most investors allocate much of their cash holdings to money market accounts or cash-equivalent mutual funds. Although these types of highly liquid investments earn only a modest amount of interest, it may be enough to offset the effects of inflation over time.

The other downside to holding cash is that it carries a significant opportunity cost. Opportunity cost refers to the loss of potential earnings that could have been generated if you had used your money differently. Since holding cash effectively generates zero profit, the opportunity cost of this strategy can be quite high. Given all the different investments available that generate guaranteed income, such as bonds and certificates of deposit (CDs), holding cash means you may be giving up the opportunity to earn significant returns.

Both cash and bonds are vulnerable to rising interest rates; Higher rates take cash away from your buying power and reduce the value of the bond.

Captivity

Unlike holding cash, investing in bonds offers the benefit of steady investment income. Bonds are debt instruments issued by governments and corporations that guarantee a fixed amount of interest each year. Investing in bonds is equivalent to making a loan for the amount of the bond to the issuing entity.

In exchange for this loan, the issuing company or government pays the bondholder monthly, quarterly, semi-annual, or annual coupon payments equal to a set percentage of the bond’s face value. The income generated from bond investments is stable and predictable, making them popular investments for those looking to generate regular income.

Once a bond matures, the issuing entity pays the bondholder the face value of the bond, regardless of its original purchase price. Investing in bonds offers the potential for capital gains if a bond is purchased at a discount, as well as interest income.

Bonds carry varying degrees of risk depending on their maturities, which can range from a few months to several decades, and the credit rating of the issuing entity. Investors can choose which type of bond to invest in based on their goals and risk tolerance. In times of economic instability, bonds and other debt instruments issued by the US Treasury are considered extremely safe because the risk of the US government defaulting on its financial obligations is minimal.

Similarly, bonds issued by highly rated US corporations are typically very low-risk investments. Of course, the interest rates paid on these high-quality bonds are often lower than those paid on junk bonds or other risky investments, but their stability can be worth it.

Additionally, bonds issued by federal, state, and local governments are generally not subject to federal income taxes, making them one of the most tax-efficient investments available.

Risks of investing in bonds

The main risk of investing in bonds is that your investment loses value. If an issuing entity defaults, you may lose some or all of your investment. Although bondholders have a greater claim on the company’s assets than shareholders, the probability of receiving the full value of their bond after a company files for bankruptcy is low, since they must first pay off their loans, mortgages, and other debts.

Your bond may also lose value if rising interest rates render it worthless in the secondary market. If new bonds with higher coupon rates are issued, the market value of your bond decreases. however, this is only a concern if you are looking to trade your bond before maturity. If you hold your bond until it matures, you are paid its face value regardless of its current market price.

Unlike keeping your money in a checking or savings account, any bond investment is uninsured. Like stocks or mutual funds, you voluntarily assume a degree of risk when you buy bonds. Because of this, the IDF does not insure these investments. If you lose money on bond investments, there is no way to recoup your losses. however, you can greatly mitigate this risk by investing in highly rated bonds and holding them to maturity.

By Master James

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