Time to Shift: The Case for Moving from Equities and Cash to Bonds

However, the T-bill & chill crowd and equity investors may want to give bonds a go.

Right now is a wonderful time to rebalance portfolios into bonds. Several factors make fixed income investments very attractive versus equities and cash. Moreover, the recent wins in these asset classes have skewed many investors’ allocations. For that reason and more, rebalancing into bonds could be the play for the rest of the year

Federal Reserve policy has driven a lot of the market’s returns this year. And the idea that the central bank will cut rates sooner rather than later has been a huge factor. Many investors have already decided that risk assets are back on the table. That meant adding a hefty amount of equities. The addition of artificial intelligence potential and surging revenues at firms like Microsoft and NVIDIA haven’t hurt either.

Year-to-date, the S&P 500—as represented by the SPDR S&P 500 ETF—is up by over 22%. This is in addition to the 21% return recorded last year. Some individual stocks have done even better, ratcheting up triple-digit returns in that time.

Those investors seeking safety haven’t done too poorly either. The Fed’s action on rates has helped here as well. Cash and cash-like asset classes are all yielding 4% to 5%+. That’s been a great return even after accounting for inflation. Just sitting in money market funds, CDs, and T-bills has been a great portfolio option for many investors.

And yet, bonds have certainly been lacking as the two rival asset classes have gained. The love for equities and the appeal of parking your money in cash has taken the wind out of bond market sales this year. Bonds have either fluctuated at small gains or even small losses this year. That’s on a return basis, which includes their coupon payments. Right now, the venerable Bloomberg Aggregate Index is sitting on a slight 0.21% total return gain for the year.

The flatness of bond returns may be a blessing for portfolios. Investors have a wonderful chance to rebalance their portfolios into fixed income assets that could deliver strong returns into next year, according to a new report from PGIM. Overall, several reasons exist as to why bonds are a good buy today and investors may want to sell some of their stocks and cash winners to get allocations back in line.

For one thing, equities are expensive when it comes to valuations. The A.I. run-up and expectations that the Fed will cut rates have boosted price-to-earnings ratios for the broader market. The S&P 500 right now can be had for a forward P/E of over 21. Just looking at the Mega-caps in the index, that P/E jumps to nearly 31, quite above historic norms.

Moreover, they are very much above the norms when comparing stocks to bonds, particularly when looking at earnings yield to bond yields. According to PGIM, comparing the earnings yield of the S&P 500 to the 10-year Treasury yield shows that equities have lost their relative valuation advantage vs. bonds. This chart from the asset manager shows the shift.

Source: PGIM

Then there’s cash to consider. Yes, the Fed’s rate hikes have made it an attractive option. But cuts make it less so. As a very short-term asset class, cash and T-bills will be the first to realize cuts and show lower yields. This fact has them underperforming bonds over the long haul. As time goes on in the cycle, cash is becoming a riskier asset class than bonds. Second, cash underperforms bonds during periods of rate cuts when stocks fall by nearly 1.5 percentage points.

So, the two main asset class winners have some warts on their faces. But what about bonds? Why should we sell stocks or cash and move into bonds? According to PGIM, their high starting yields are a huge reason.

The Fed’s path to higher rates has created an environment for yields not seen since 2002. Those higher starting yields have historically resulted in higher total returns. Remember, bonds mostly get their returns from their yields. Locking in 4% to 6% in cash goes a long way to getting that return. Historical data proves this.

Looking at 10-year periods, PGIM found that a higher starting yield will result in a stronger total return. For example, 1992 to 2002, yields on the Agg were 6.76%. With that, bonds returned 7.45%. During 2012-2022, starting yields were only 1.75%. As a result, bonds only managed a 1.27% return for the period. With yields now at 4.68%, historical patterns suggest investors should realize a decent positive return. ¹

With that, the case for rebalancing into bonds is strong. Equities are expensive and perhaps overpriced. This could be an ominous sign if the Fed misses and we get a hard landing. At the same time, cash is getting riskier as time goes on. When the Fed does cut, those juicy 5% yields will fall fast, causing plenty of reinvestment risk.

That means that bonds—with their flat returns—are some of the only opportunities left around. For that reason, it makes sense to take advantage and add them to a portfolio.

These ETFs were selected based on their low-cost exposure to core bonds, Treasuries, investment-grade corporate bonds, and mortgage-backed securities. They are sorted by their YTD total return, which ranges from -0.5% to 0.6%. They have expense ratios between 0.03% and 0.36% and assets under management between $55M and $314B. They are currently yielding between 3.6% and 4.8%.

Overall, both equities and cash have a lot more risk than investments are giving them credit for. And that means that bonds could be the best bet. Selling some of our winners and repositioning into fixed income could be a great win for portfolios heading into the new year.

Bonds could be a great rebalancing opportunity for portfolios. Thanks to high equity valuations and reinvestment risk on cash, bonds’ relatively flat returns and high starting yields provide plenty of prospects for success. Adding to our bond positions and selling some of our winners makes a ton of sense.

¹ PGIM (June 2024). The Case For Rebalncing Into Bonds, In Pictures