Should you replace bonds with cash?

A bond index fund is probably a better choice

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bonds vs. cash

(Peter Dazeley/Getty Images)

Not many investors are enthusiastic about bonds these days, and it’s hard to blame them. While rates have ticked up in the last few weeks, they’re still so low that even some sophisticated investors have abandoned them altogether. I’ve spoken to some investors who are ready to follow that advice, though they are not prepared to ride the roller coaster of a 100%-equity portfolio. So they’re asking whether they should just swap their bonds for cash.

At first blush, this looks like a good strategy. As of May 6, the yield tomaturity on short-term bond ETFs is barely 1% after fees. Even broad-based bond ETFs (which have average maturities of about 10 years) have a yield to maturity well below 2% after accounting for management fees. Meanwhile, most investment savings accounts (ISAs) are paying at least 1%, and if you hunt around you can find high-interest savings products with much better yields: Equitable Bank offers one at 1.45%, while People’s Choice has a savings account at 1.60% and a TFSA savings account at 2.25%. Why take risk with a bond ETF when you can get a higher yield from cash, with no volatility and CDIC insurance to boot?

There are many situations where it does indeed make sense to use a high-interest savings account rather than a bond fund. Certainly if you are putting money aside for a short- to medium-term goal—like a down payment or other major purchase—cash is king. But if you’re a long-term investor with a diversified portfolio, a bond index fund is probably a better choice. Let’s look at why.

It’s not just about yield

Bond yields are dismal today, but let’s remember that you add bonds to a diversified portfolio not to boost your returns, but to dampen your overall volatility. Bonds funds can fluctuate in value, but they are nowhere near as volatile as equities, so they’re like adding cool water to a hot bath to make it more comfortable.

Adding cash to an equity portfolio will also lower the volatility, too, but nearly not as much. That’s because bonds tend to have negative correlation with equities during times of market turmoil. In other words, when stocks plummet and the economy is in recession, interest rates typically fall, which drives bond prices up. That boost can offset at least some of the losses you experience on the equity side of your portfolio.

You don’t have to go back very far to see some examples. In 2008, when the global stock market shed about a third of its value, broad-market bond index funds delivered over 6%. And during the turmoil of 2011, when Canadian and international stocks tanked, bonds returned well over 9%. That cushioned the blow and provided opportunities for rebalancing by selling some of those bonds and buying equities with the proceeds.

Holding cash in your portfolio during a stock market correction offers a much smaller benefit. Your savings account will never spike in value and offset losses on the equity side, and it’s likely to disappoint if a recession rears its head. When interest fall, savings accounts simply see their yields fall, so they’ll pay you less going forward.

It’s always important to consider asset classes in context, rather than in isolation. On their own, investment-grade bonds are unattractive today if your goal is simply to earn interest income in the short term. But if you’re in it for the long haul, never forget that bonds are still the asset class that puts the balance in a balanced portfolio.

An evening with Dan Solin

On Thursday, May 28, the Waterloo office of PWL Capital will be hosting an event with Dan Solinfinancial author and passionate investor advocate. Dan will discuss how investors have grown discouraged by the financial industry, and how the smart ones are waking up to a different way of thinking. His talk will be of interest to all investors who are looking for a better approach to building wealth.

We’re setting aside five tickets for Canadian Couch Potato readers. If you’re interest in attending, please contact Susan Daley at sdaley@pwlcapital.com.

4 comments on “Should you replace bonds with cash?

  1. “a bond index fund”?? omg

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  2. What on earth do you mean by that? Buying individual bonds isn’t especially consumer-friendly. You need to pay attention to your costs, both MER and trading, for both methods. Do you suggest GIC’s for the fixed income portion of the portfolio, and what do you think override’s Dan’s argument?

    Reply

  3. In normal times, interest rates could fall, so making bond prices rise. But how can interest rates fall from today’s minuscule yields.

    Surely interest rates can only rise from here, making bond prices fall . So as far as I can see, bonds will deliver a tiny return and are likely to lose value over the long term.

    Please tell me where my logic is incorrect …

    Reply

    • Interest rates can go negative, as we’ve recently seen in Europe and Japan. E.g., interest rates are currently at -0.75% for Switzerland and -0.30% for Sweden.

      Both the Canadian and US governments have said they would consider adding negative interest rates to their funny money toolbox.

      Reply

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