Comparing Money Market Funds and Government Bonds

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Introduction

DIY investors have increasingly favoured money market funds over traditional government bonds (gilts), drawn by recent pockets of outperformance. However, a deeper technical evaluation suggests that replacing gilts entirely with cash‐equivalent vehicles can suppress long-term returns and leave portfolios under-diversified when equities tumble. Below, we compare the assets across multiple horizons, examine interest-rate mechanics, and outline how to construct a resilient defensive sleeve.

1. Performance Across Multiple Horizons

1.1 Five-Year Real Returns

• Money market (ETF proxy): real annualised ≈ -2.0%
• Intermediate gilts (All-Stock index): real annualised ≈ -9.2%

From mid-2020 through May 2025, steep rate hikes drove gilt prices down roughly 28% nominally (≈38% in real terms). Short-duration money market vehicles also lagged inflation, but with only a ~10% real drop.

1.2 Ten- and Fifteen-Year Returns

1. Ten-year real: money market ≈ –1.5%; gilts ≈ –3.6%.
2. Fifteen-year real: money market ≈ –1.8%; gilts ≈ –0.9%.

The hazard period around the 2008–09 financial crisis inflicted sub-zero cash returns for more than a decade, whereas gilts benefited from record-low yields into the mid-2010s.

1.3 Long-Run 125-Year Record

Over the 1870–2025 span, gilts have delivered twice the real return of money market instruments, according to Jordà et al. (2019). This signal-rich dataset spans wars, deflations, stagflation, tech busts, and pandemic shocks, underscoring the risk-reward trade-off: higher volatility in bonds earns a durable premium.

2. Yield Curve and Duration Dynamics

“Duration is price sensitivity to yield changes,” notes a 2024 BlackRock fixed income primer. Intermediate gilts have a Macaulay duration near 6 years and modified duration ≈ 5.5. A 100 basis-point uptick in yields can thus shave >5% off bond NAVs.

• Short duration (money markets): ≈ 0.1–0.2 years — minimal mark-to-market volatility but significant reinvestment rate exposure.
• Intermediate gilts: ≈ 5–7 years — higher income carry (current 10-year UK gilt yield ~4.3%), but greater price swings.

As central banks pivot, the yield curve’s shape dictates which bucket wins. In early 2025, Bank of England base rate has held at 5.25% since December 2023. Money market rates are near peak, but anticipated cuts in H2 2025 will erode cash yields faster than bond coupons.

3. Credit, Liquidity and Counterparty Considerations

Money market funds invest in Treasury bills, repo agreements, and high-grade commercial paper. They carry:

• Minimal credit risk (often government‐backed instruments).
• High liquidity — daily redemption with minimal bid-ask spreads.

By contrast, gilts are subject to sovereign risk, market depth constraints in stress, and occasional gilt repo haircuts — as seen during the September 2022 mini-budget flash crash. Proper sizing of each exposure helps mitigate idiosyncratic drawdowns.

4. Scenario Analysis: Stress Testing Defensive Buckets

Stagflation environment: Gilts struggle as yields rise to fight inflation, cash carries better real returns.

Deflation shock: Both assets gain real purchasing power, but gilts deliver capital appreciation as yields fall sharply.

Equity crash: Gilts often rally (negative correlation with stocks), whereas money markets cut only carry risk, offering limited price relief.

5. Constructing a Diversified Defensive Portfolio

Rather than an either/or choice, investors can blend assets to smooth returns and diversify risk factors:

• 40% short-term money market funds (floating exposure to cash rates).
• 40% intermediate government bonds (carry and diversification).
• 20% inflation-linked gilts or commodities (real rate hedging).

Such a blend balances reinvestment flexibility, price volatility, and inflation protection. Vanguard’s 2024 Fixed Income Outlook suggests adding 5–10% in index-linked bonds to guard against persistent inflation surprises in later retirement stages.

6. Expert Opinions

• Vanguard: “A core fixed income sleeve should combine short and long duration to capture both coupon carry and defensive diversification.”
• IMF (2024 Global Financial Stability Report): “Flight-to-quality dynamics during systemic stress favor longer-dated sovereigns over cash for capital preservation.”
• BIS Quarterly Review: “Yield curve steepening episodes historically reward investors positioned across the curve.”

Conclusion: No Universal Winner

Money markets and government bonds each serve distinct defensive roles. Cash offers stability and rapid reinvestment at prevailing rates, useful when rates are rising. Gilts, with longer duration, provide portfolio ballast during equity crashes and deliver a long-run premium for enduring volatility. Combining exposures alongside inflation-linked securities yields a robust defensive framework capable of navigating diverse macro regimes.

Categories and Tags

• Categories: investing, finance, markets
• Tags: money market, government bonds, duration, yield curve, fixed income