Why are bonds better than savings accounts? Which bond ETFs are safe?
September 11, 2018 8:44 PM   Subscribe

As someone trying to maintain a small diversified portfolio, financial theory suggests that it is prudent to hold a mixture of asset types, with bonds especially often proposed as an alternative to more volatile equities. Is it worth the risk of diversifying into bonds and, if so, what's a good investment vehicle?

But looking at return data over the last ten years or so, ETFs of popular types of government and other bonds don't have great looking returns. Tangerine savings accounts pay 1.25% at the moment, while the back pages of The Economist say consumer prices are up 2.2%. It's losing to inflation, but as a deposit-insurance protected bank account it doesn't face the risks of something like an index-tracking ETF composed of the NYSE or TSX. Are there ETFs comprised of big sets of bonds that face a low risk of losing the principal and might be expected to pay a return above inflation over multi-decadal timescales?
posted by sindark to Work & Money (9 answers total) 2 users marked this as a favorite
For the sake of comparison, one of Tangerine's mutual funds has gone from being worth $9.20 per unit on 2012-05-24 to $15.40 per unit on 2018-08-14.

An ETF tracking some stock markets minus the fossil fuel industry has gone from $101.32 on 10-Feb-17 to $117.46 on 2018-08-14. A comparable ETF (in terms of composition) seem to be the Vanguard Total Stock Market ETF and it has gone from $135.53 on 2018-04-24 to $146.65 on 2018-08-14.
posted by sindark at 8:54 PM on September 11, 2018

Are there ETFs comprised of big sets of bonds that face a low risk of losing the principal and might be expected to pay a return above inflation over multi-decadal timescales?
If someone tells you that the answer to this question is "yes", and they're not talking about treasury bonds (or other US government bonds), be very suspicious.

The nominal point of high quality bonds in a diversified portfolio is not to diversify the number of ways you can make money, which seems to be the unspoken assumption of your question. It's to hold some fraction of your assets in a class that historically has not decreased enormously in value, and whose returns, such as they are, are not positively correlated with those of stocks. These two properties make your portfolio more robust when the stock market crashes, for example.

This means that, yes, historically, on average, over decadal time scales, there's an opportunity cost to having money in bonds rather than stocks. Whether this expected (but not guaranteed) cost is a price worth paying in return for a reduced downside in times of economic turmoil depends entirely on your personal circumstances, your investment goals, your time horizon, and your tolerance for risk. No one can answer that question for you.

But very generally speaking, if you're saving for retirement and your daily expenses are under control, a non-crazy thing to do might be to have a percentage of your assets equal to your age in bonds. This increases your bond allocation as you approach retirement. It's seen as a wise thing to do because, as you age your ability to recover from losing all your money in a stock crash goes down because you have fewer years left to earn money. At qualitative level, this is how "Target Date" retirement funds behave. These are often the default investment for an employer 401k, precisely this is such a reasonable and uncontroversial strategy.

p.s. Certain kinds of bonds in the context of certain kinds of portfolios can sometimes have tax advantages if you're holding them in a non-retirement account. These can be significant.
posted by caek at 9:22 PM on September 11, 2018 [10 favorites]

Adding bonds is not about increasing returns directly - rather, it's a specific application of a more general idea: diversification. The main idea (in modern portfolio theory) is to invest in assets that are uncorrelated, or low-correlated, so that market events won't wipe out an entire portfolio, and to increase the risk-adjusted return.

For example, I used Portfolio Visualizer to draw up an efficient frontier chart for a portfolio made up of the US Stock Market and Long Term T-Bills. We can see that a 100% stock market portfolio has the maximum historical return, and also the maximum deviation. The tangency portfolio has the highest Sharpe ratio at approx 51 % Stock Market and 49% treasury bills.

But portfolio construction is dependent on personal risk tolerance, asset availability, time horizons, needed rate of return, and other personal considerations.

Return data for the last 10 years includes the fallout from 2008. Black Rock's US Aggregate Bond (AGG)has a10 year return of 3.6%, while Core Canadian (XBB) 10 year return is 4.03%.

Other ways of adding diversified assets are precious metals, real-estate investment trusts, and international assets.

Are there ETFs comprised of big sets of bonds that face a low risk of losing the principal and might be expected to pay a return above inflation over multi-decadal timescales?

I don't know that any one asset is a multidecade prospect. It may be more helpful to think of asset mixes as being correct for personal situation, risk tolerance, and time horizon. I think the asset class you're looking for are known as High Yield Bonds, either low-rated corporate or "junk" bonds. Things like HYXU or HYG or VWEHX

The canonical inflation-protected security are Treasury Inflation-Protected Securities (TIPS) (US) Real Return Bonds(CAN)
posted by the man of twists and turns at 9:26 PM on September 11, 2018 [2 favorites]

That is all extremely helpful, thank you!

caek is right that risk of loss is highly relevant. It seems like an argument in favour of the 1.25% from the deposit-insured account.
posted by sindark at 9:48 PM on September 11, 2018

I like caek's advice but I'll just add that if you're going to open a savings account, do check around for rates, because I bet you can do better than 1.25% -- I'm in the US, but Ally has 1.85% APY right now and some banks here are even slightly better.
posted by karbonokapi at 10:05 PM on September 11, 2018

Yes, you can do better than Tangerine. In Canada right now you can get as good as 2.3% in a CDIC insured account (at EQ bank).
posted by quaking fajita at 5:34 AM on September 12, 2018

Read Andrew Hallam's Millionaire Teacher. It explains many of the basic concepts needed to start investing / saving for the future, and has some great humour. It is a very good and informative read.
posted by Sauter Vaguely at 7:04 AM on September 12, 2018

After reading this Reddit post on Series I Bonds, I started building an emergency fund ladder with them -- I have it set to automatically buy $1000 in I Bonds every six months.
posted by rabbitrabbit at 11:40 AM on September 12, 2018

I think most people hold bonds in retirement accounts where afaik savings accounts are not an option.

Then the are people who are so wealthy they need something to do with more money than FDIC insures, even across several accounts.
posted by Salamandrous at 5:51 PM on September 12, 2018

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