The cash-heavy strategy has worked during this period, because cash and very short-duration securities are much less sensitive to interest rate increases. As a rule, when interest rates rise, bond prices fall—but less so at the short end than for longer-duration securities.

For example, the Bloomberg U.S. 3-Month Treasury Bellwether Index, a benchmark for Treasury bills with a maturity of less than three months, returned 1.51% in 2022. That compared with a return of –13% for the Bloomberg U.S. Aggregate Bond Index, which represents the U.S. investment-grade market. 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 

But continuing to overweight cash may prove to be another example of how what worked in the past may not work so well again in the future.

With an economic downturn widely expected by markets in later 2023 or early 2024, it may be a good time to reassess how your fixed income portfolio is invested across maturities.

Trying to maximize yield today by overweighting cash or very short-term bonds in the inverted yield-curve environment has trade-offs. Moving out further on the yield curve may let you take advantage of higher yields and better defend your portfolio from weakness in equities.

Of course, the best practice is to align the duration of your portfolio allocation with your approximate timeline, especially if money will be needed relatively soon. For needs within a year or so, cash remains an appropriate option, while short-term bond funds can work well for needs within the next few years. 

With yields higher than they were a year ago, bonds can absorb some pain if rates continue to rise—without leaving investors with large losses.

For example, the Bloomberg U.S. Treasury 3–10 Year Bond Index, an intermediate-term measure, had a duration of 5.1 years as of January 31, 2023. That means the index could see a 5% price decline if interest rates suddenly rose by 1 percentage point across the board.

However, the 1-percentage-point increase would mean higher income, which would counter the index’s price decline over the next year and result in a total expected return of –0.51%.

Conversely, if rates were to fall by 1 percentage point, an intermediate-duration portfolio such as the 3–10 Year Index would be poised to see greater capital gains than a portfolio with a shorter duration such as the 1–3 Year Index. The estimated one-year return would be 7.75% versus 5.14%, or about 50% higher than if rates were unchanged.

These hypothetical estimates are based on Treasury rates and do not include the potential impact of credit spread widening or the benefit of higher yields in corporate bonds. 

So, what is the matter with staying short?

If interest rates, especially short-term ones, fall, then investors in cash will be faced with the risk of reinvesting at a lower rate, reducing the yield component of future total returns.

In addition, investors whose portfolios are short in duration would miss out on greater capital gains in a scenario where longer-duration bonds also experience yield declines. What’s more, prices on longer-term bonds often rise when equity markets drop as investors seek safety. Therefore, less duration exposure deprives a portfolio of the equity hedge that longer-term bonds can provide in volatile markets.

If your view is that further rate hikes not currently expected by the market may still occur in the near future, short-term bonds may provide a better shield against this risk and still offer highly attractive yields today.

But we believe that what makes sense for most investors is to consider diversifying your fixed income allocation across the maturity spectrum, potentially by moving away from cash-like exposure and toward short-term bond strategies or, for longer investment horizons, to a broad, high-quality strategy like core or core plus.

Here is a sampling of Vanguard bond funds and ETFs across a range of maturities:

• Vanguard Ultra-Short-Term Bond Fund
• Vanguard Short-Term Investment-Grade Fund
• Vanguard Core Bond Fund
• Vanguard Core-Plus Bond Fund
• Vanguard Short-Term Bond ETF
• Vanguard Total Bond Market ETF
• Find more