Bonds vs. Cash: Key Differences in Liquidity, Income, and Taxes

Choosing between bonds and cash involves trade-offs that affect your financial strategy. While both are safer than stocks, they differ in accessibility, income potential, and tax treatment. Understanding these differences is key to aligning your choice with your financial goals.

Liquidity Differences

Cash, whether in a checking account, savings account, or physical form, is immediately available and does not fluctuate in value, making it ideal for emergencies or short-term expenses.

Bonds, on the other hand, must be sold or reach maturity to be converted into cash. U.S. Treasury bonds and high-quality corporate bonds are actively traded and can often be sold quickly, but their prices fluctuate with interest rates. If rates rise after purchase, a bond’s price falls, meaning selling before maturity could result in a loss.

Liquidity varies by bond type. U.S. Treasuries are highly liquid due to strong demand. Corporate bonds, especially those with lower credit ratings, may take longer to sell and might require a discount. Municipal bonds, though offering tax benefits, typically have lower trading volumes, making them harder to sell quickly at a favorable price.

Income vs. Holding Value

Bonds provide income through interest payments, known as coupons, typically paid semiannually. For instance, a corporate bond with a 5% annual coupon and a $1,000 face value pays $50 per year, split into two $25 payments. This steady income appeals to retirees and income-focused investors.

Cash does not generate income unless placed in an interest-bearing account. Savings accounts, certificates of deposit (CDs), and money market accounts offer interest, but rates fluctuate with Federal Reserve policy. In early 2024, high-yield savings accounts and money market funds offered 4% to 5%, sometimes matching bond yields. However, these rates are not fixed like bond coupons and can decline over time.

Bond prices fluctuate with interest rate changes. If rates drop, existing bonds with higher coupons become more valuable and can be sold at a premium. If rates rise, bondholders may see their investments lose value unless held to maturity. Cash remains stable in nominal value but loses purchasing power over time due to inflation.

Inflation Considerations

Inflation erodes purchasing power, meaning cash holdings lose value unless placed in high-yield accounts that match or exceed inflation. If inflation averages 3% annually and a savings account offers 2%, the real return is negative.

Bonds offer some inflation protection, but fixed-rate bonds become less attractive in an inflationary environment as their payments lose purchasing power. Long-term bonds are particularly vulnerable due to inflation uncertainty. Treasury Inflation-Protected Securities (TIPS) adjust with the Consumer Price Index, maintaining their real value.

Short-term bonds help mitigate inflation risk since they mature quickly, allowing reinvestment at higher rates if inflation pushes interest rates up. Holding large amounts of cash during inflationary periods guarantees a loss of purchasing power unless placed in high-yield instruments that adjust to rising rates.

Tax Treatments

Interest earned on savings accounts and money market accounts is taxed as ordinary income in the year received, subject to federal, state, and local taxes, which can significantly reduce yields for high-income earners.

Bond taxation varies by type. Corporate bond interest is taxed as ordinary income at both federal and state levels. Municipal bonds, issued by state and local governments, offer tax advantages: their interest is exempt from federal taxes and may also be state tax-free if purchased by a resident of the issuing state. This makes them attractive for high-income investors seeking tax-efficient income.

Maturity Structures

Bonds have fixed maturity dates, ranging from months to decades. Short-term bonds (one to three years) provide flexibility and lower risk, allowing reinvestment at prevailing rates. Intermediate-term bonds (four to ten years) balance risk and return, offering higher yields than short-term options while being less sensitive to interest rate changes than long-term bonds. Bonds exceeding ten years, such as 30-year U.S. Treasuries, generally offer the highest yields but are more exposed to interest rate and inflation risks.

Cash has no maturity date and remains available indefinitely. This makes it ideal for liquidity but limits long-term growth potential. Cash equivalents like CDs and Treasury bills have fixed terms, often ranging from weeks to a few years. Investors prioritizing capital preservation may prefer cash or short-term instruments, while those seeking higher returns may opt for longer-dated bonds despite their increased exposure to market conditions.