Benstead on Bonds: how to use markets to earn more on your cash

Holding cash in a broker account, or with a bank, offers a safe and reliable return – but investors can nearly always do better if they harness the power of financial markets.

To explore this, last week I hosted a webinar with three portfolio managers about the alternatives to holding cash. The aim was to provide the “menu” of cash-like investments that are available to retail investors.

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My guests were David Coombs, who is head of multi-asset investing at Rathbones Asset Management, Tim Foster, who manages fixed income and money market portfolios at Fidelity International, and Jamie Irvine, a fixed income manager at Aberdeen, where he runs their short-dated corporate bond fund.

• Watch the webinar: what are the best alternatives to holding cash?

Money market funds

For me, the most important point to understand is that “cash” means a very different thing for professional investors than it does for DIY investors. For the DIY cohort, it normally means uninvested cash or cash in a bank savings account, which normally does not earn a competitive return.

But for fund managers, cash typically means money market funds. These are funds that are professionally managed to give an ultra-safe “cash-like” return. They use bonds maturing within just a couple of months alongside an array of short-term savings tools offered by banks.

• Watch our video: how bonds work and why you should own some
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Yields are typically just ahead of the Bank of England interest rate (currently 4.5%), while fees are normally very low (between 0.1% and 0.2%). Money market funds can be held inside a stocks and shares ISA or a pension.

Fidelity Cash manager Tim Foster explains: “Money market funds are basically the lowest risk kind of fund that we can make, but it is a fund and does have a level of credit and interest rate risk.

“They are regulated and there are strict regulations about what you can put in a money market fund. Average maturities are not more than two months and are typically around one month. The investments are highly rated by credit agencies. They are also very liquid and we have about one-third or 40% of the fund maturing each week.”

A key point to note about money market funds is that yields will rise and fall alongside interest rates. So, while yields are currently around 4.5%, if the Bank of England interest drops below 4% by the end of this year, as many market experts expect, then returns will also fall.

Gilts

For investors looking to lock in a cash-like return, short-term gilts are one fantastic option.

When you buy a gilt, you are effectively lending to the UK government. When you own the gilt (which are traded on the ii platform), you get paid two coupons a year and you get back the initial sum the government borrowed when it issued the gilt, which is £100 per gilt.

For example, one of the most popular gilts on our platform today is UNITED KINGDOM 0.125 31/01/2028 (LSE:TN28).

It costs £90 today and redeems at £100 in January 2028. In the meantime, it pays 12.5p per year in coupons. The all-in yield of holding the bond to maturity is 3.7% a year, with the vast majority of that return coming from the 11% increase of the bond’s value from £90 to £100 as it nears maturity, which is counted as a capital gain and is tax free.

Because the UK government is one of the most secure borrowers in the world, the chance that you won’t get your money back, especially over such a short period, is effectively zero.

Coombs explains: “Gilts are UK government bonds. You are lending money to the country. You are helping to fund government expenditure. Because you are lending to the government rather than to a company, it is seen as a low-risk type of investment.”

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Coombs flags that gilts come in different maturity lengths. “The longer you lend to the government for, the riskier it becomes. In terms of short-dated gilts, like less than five years, they are reasonably safe alternatives to holding cash. They can still move in price on a day-to-day basis, but they are easy to trade and your money is not locked up.

“We use gilts in my funds and in my own personal portfolio, particularly today given yields are quite high, at between 4% and 5.5%, depending on the maturity of the bond. You can buy and lock in rates,” Coombs says.

He says the main difference between using gilts as a cash savings tool compared to a money market fund is that you are lending to the government with a known end date for the gilt, with a set yield when you buy the gilt, known as the yield-to-maturity.

Whereas on a money market fund, Coombs says the fund is “perpetual” in the sense that the manager is constantly adding new positions to the fund, and so the yield will change over your ownership period.

“A money market fund is more of an instant-access product whereas you can lock a return in with a gilt,” adds Foster.

Short-dated corporate bonds

Investors can earn more, but with some added risk, if they move money into corporate bond funds. In contrast to gilts where the UK government is taking out a loan, corporate bonds are where companies come to financial markets for cash. Lending to a company rather than a government is riskier, and therefore there is a “spread”, or excess yield.

Like other bonds, the shorter the time until the bond matures, the less risky it is. Short-dated corporate bonds generally mature within five years. However, there is more credit risk and duration (sensitivity to interest rates) risk than you would have from a money market fund.

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Irvine, who manages the abrdn Short Dated Corporate Bond fund, says: “When we talk about corporate bonds, it is an extra layer up in the risk spectrum. So, you are getting an additional yield over government bonds. This can generate attractive yields of 5% to 6%.”

He says that while this has more risk than cash, these bonds are very liquid, and over the past 25 years, short-dated corporate bonds have outperformed cash for 18 of those years.

Irvine adds: “The drawdowns are much lower than broader corporate bond funds in times of risk off, such as in 2022. Gilt portfolios saw losses of between 15% and 20% in 2022, when that is technically a ‘risk-free’ asset.

“But here ‘risk free’ means free from credit risk. Drawdowns for short-dated corporate bonds were still significant, at 8% in 2022, but losses were recovered by 2023. Generally, drawdowns for short-dated corporate bonds are between 0.5% and 1% on down years.”

Here’s my short summary of the three “cash-like” investments discussed.

Money market funds

Pros: attractive yields today (around 4.5%), low fees, very low risk.

Cons: yields will rise and fall as interest rates change.

Short-term gilts

Pros: lock-in a yield, no fees (other than trading fees), ultra-secure as the UK government has never defaulted, no capital gains tax due, so low-coupon gilts held outside an ISA or SIPP deliver fantastic tax-adjusted returns.

Cons: can be complicated to understand, could get a better return if interest rates rise in the future, prices can move over the life of the gilt.

Short-term corporate bonds

Pros: better yields than money market funds or gilts.

Cons: more credit and duration risk means more volatility and potential for losses.