Should You Replace Bonds With Cash?

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 to maturity 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, but not nearly 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 rates fall, savings accounts savings accounts will just 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.

 

72 Responses to Should You Replace Bonds With Cash?

  1. Sven June 15, 2015 at 10:01 pm #

    @ccp,

    Could you please explain why the price of VAB has been decreasing since we saw a jump in price (as expected) in February, when the Key Interest Rate changed from 1% to 0.75%?

    I understand the economics of VAB price increasing when the rate goes down, but since February the rate has stayed steady at 0.75% – so why hasn’t the price of VAB stayed steady since then? It’s now back down to the price in January, before the rate drop.

    Yes, we invested heavily into VAB at the peak price in February, and now having second thoughts, although plan to hold it for 10+ years.

    Thanks!

  2. Canadian Couch Potato June 15, 2015 at 10:51 pm #

    @Sven: Good question, as this idea is frequently misunderstood. There is no single interest rate: there are many. The one that gets all the headlines is the overnight rate, which is the shortest of short-term rates. It has little or no effect on the bond market. The more relevant rates for VAB and similar bond funds are the yields on 5-year, 10-year and longer-term bonds. All of these rates have moved up significantly since mid-February:
    http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/

    This post may help:
    http://canadiancouchpotato.com/2013/06/10/whats-happening-to-my-bond-etf/

  3. Sven June 16, 2015 at 12:24 am #

    Ahhh! That makes more sense! Thank you!

    You’re website has been super helpful! Thank you for all your efforts Dan.

  4. Fazza July 5, 2015 at 11:53 am #

    My portfolio is hyper aggressive. 90% equity, 10% cash with lots of time to ride out many storms ahead. Of course would like to re-balance but feel the timing is just not there. Sorry I find bonds/bond funds confusing and likely one reason I’ve avoided them.

    Rather than cash or bond fund maybe the ‘sure thing’ for me is finish off small mortgage (<$100,000)? Only thing is my variable rate is ridiculously low at 1.95% and maybe getting lower. I'm not asking for advise on pay down mortgage versus RRSP. It just seems that one could 'balance' out their portfolio by making sure other liabilities outside their portfolio are considered at this time of uncertainty.

    Is this faulty logic to go for the guarantee versus what seems like the uncertainly of bond funds at present?

  5. Canadian Couch Potato July 5, 2015 at 1:33 pm #

    @Fazza: Paying off your mortgage instead of investing may or may not be the right decision for you, but whatever you decide, I would encourage you not to think in terms of “paying off my mortgage is an alternative to buying bonds.” When you have a mortgage you’re a borrower; when you buy bonds you’re a lender. A mortgage is a liability and a bond is an asset. So I would not approach the decision with that mindset.

    I would be more concerned about how you would react if your portfolio fell 30% or more. A portfolio of 90% equities is easy to handle during a long bull market, but many investors have forgotten what it feels like to experience a deep bear market that lasts a year or more.

  6. Brian G July 9, 2015 at 1:16 am #

    I replaced my bonds with cash, US cash and short term bonds (XSB) a few years ago. I am happy with that decision so far. I don’t really trade the USD vs. CAD I just hold on to both and don’t care if either goes up or down. I think of this as being a world-neutral currency strategy vs. holding one or the other which would be betting on one currency vs. the other. I’ve managed my currency risk this way for many years with stocks but now I am doing it this way with cash and bonds too.

    I’ve always been leery of just holding Canadian cash because when there is a panic towards safety, the US dollar appreciates and the Canadian dollar depreciates. Also, the rest of the world sees our currency as a commodity linked currency. So it’s more volatile like the AUS and NZD.

    I am thinking of adding short term US Treasuries (SHY) if they ever raise rates but I won’t hold my breath. The US Fed has lied (cried wolf) for years.

  7. Eric July 10, 2015 at 11:55 am #

    Hi,

    I’ve noticed that the duration and Maturity of the Vanguard total bond fund in the US are both significantly shorter than in Canada.

    Unless I am reading this wrong…. Vanguard Total Bond Market Index Fund Investor Shares (VBMFX):

    Average effective maturity 7.9 years
    Average duration 5.7 years

    VAB in Canada:

    Average effective maturity 10.8 years
    Average duration 7.6 years

    This is a bit of a concern in this environment as VAB is getting up there in term length (though still medium) and some research suggests a 5 year duration as being a reasonable bet for long term investors (10 year plus, say). A lot of the discussions center around the US Total bond market. There must be a limit on how high one would want to go, otherwise why not a 30 year bond if you don’t need the money for 30 years?

    I’m considering a mixture of VSB and VAB to get it down to 5 years (GIC range) to hedge my bets. Any thoughts on this?

    Thanks.

  8. Canadian Couch Potato July 10, 2015 at 2:53 pm #

    @Eric: Funds like VAB and VBMFX take a cross-section of the total bond market rather than targeting a specific average maturity, so it looks like the US bond market just happens to have fewer long-term bonds available. There’s nothing at all wrong with using two bond ETFs to achieve a duration your more comfortable with: you don’t necessarily have to go with whatever VAB or VSB happens to be.

    As for a limit on how high you would go, there has been some research on this. In very general terms, short and intermediate maturities (say, 10 years or less) seem to offer a better risk-reward trade-off: long-term bonds have delivered higher returns over long periods (which is what you would expect) but they can be very volatile. Precious few investors are comfortable with double-digit swings on the bond side of their portfolios, and it’s hard to blame them. It’s generally best to take most of your risk on the equity side and use short or intermediate bonds for some stability.

  9. Eric July 10, 2015 at 3:21 pm #

    So, if you have nerves of steel, you will always get a better return on the bond side with a longer duration, assuming you hold until their maturity? But in the meantime they are tossed around more violently with prevailing rates of the same term?

    But that is looking at them in isolation, with rebalancing might you not want your bond allocation to be stable?

    I estimate that with a 60/40 split of VAB/VSB you will match the US duration. Though I guess both the US and Canadian durations are arbitrary.

    This may be a naive question, but is there anyway to estimate the “best value”. For example, if I look at the Canada yield curve you seem to get a nice gain from 3 to 5 years then much less from 5 to 7 years. I would think that suggests 5 years or so is a pretty good deal at the moment?

  10. Tristan July 10, 2015 at 4:38 pm #

    Eric, you bring up some interesting questions which I also struggled with for some time, so here’s my take on it which may help.

    Many authorities suggest the best risk/reward profile lies at about the 4-5 year term (or duration, as it doesn’t have to be exact), hence the advice to own a 1-10 year bond ladder or a bond fund(s) with the same duration. You could do that with a mix of ZFM (BMO Mid Federal Bond), which has a duration of 6.9 and VSC (Vanguard Canadian Short-term Corporate Bond), which has a duration of 2.8 years.

    However, as Jack Bogle says “simplicity is the master key of financial success”. It’s just simpler to have one fund. Why have two funds when one will do? VAB is good intermediate term bond fund. It’s duration is a little bit longer than 5 years, but the difference between 5 and 7.6 is really nitpicking in terms of the big picture. It will go down a bit more when/if interest rates rise and you will need to hold it for a bit longer to get your money back as, worse case, you may need to hold bond funds for their duration to get your money back. But for a long term investor that doesn’t matter.

    With regard to your second post, you get more risk than return beyond terms of about 10 years, which is why most people recommend intermediate term bond funds. In the context of a portfolio, intermediate bond funds are more efficient than long term bond funds, except for high equity allocations.

    I think there’s little to be gained from targeting the the most efficient point on the yield curve. Then you have to monitor it, and change it when indicated. Just keep it simple and buy VAB!

  11. Brian G July 10, 2015 at 5:17 pm #

    FYI… The US duration is likely shorter because the Fed’s Quantitative Easing programs (QE1,2 and 3) that have been “purchasing” government long Treasury bonds since 2008 and thus taking them out of the market.

    I’ve searched for how much they’ve bought and they best I could find was in a speech made last year where the estimate was given that they now hold 24% of Treasuries. Buying has continued so it’s clearly higher now. Source: http://www.dallasfed.org/news/speeches/fisher/2014/fs140404.cfm

    So basically, 25%+ of long government bonds have disappeared from the market and thus the universe of tradable bonds has shortened in duration. There may also be other factors but it’s one factor.

    The same thing didn’t happen in Canada.

    Knowing that the US can just effectively print money to “purchase” bonds… what does that say about their real worth long term? It’s almost a 100% guarantee that when the dust settles, inflation will win and thus why most smart investors like Buffet, Bill Gross and others want to short them if they could.

  12. Eric July 10, 2015 at 6:39 pm #

    Tristan, nitpicking seems to be my specialty. I’ve only been looking at this for about a month and I have been down many rabbit holes and back. But I tend to always come back to the following:

    Vanguard Canadian Aggregate Bond Index VAB 20%
    Vanguard FTSE Canada All Cap Index VCN 25%
    BMO Equal Weight REITs ZRE 10%
    Vanguard FTSE All-World ex Canada Index VXC 45%

    In addition I have set up a glide path in my spreadsheet, like the one used by Vanguard in the US, so that it automatically adjusts the weighting of the bonds/stocks based on the current system date.

    What I find, as many other have, is the main challenge is not technical, but psychological. My personal flaw is to tinker. The couch potato program makes sense, but I would personally prefer if it was more technically challenging. Luckily, I’ve started looking at this in advance of when we pay off our house (soon), so my rabbit holes have only been theoretical and haven’t done any damage (yet). There needs to be a Bogleheads anonymous self help group in which you can confess your tinkering sins. On the other hand, I learn something from each trip down the rabbit hole.

    Brian, a very interesting observation. I hadn’t thought of that.

  13. Canadian Couch Potato July 10, 2015 at 9:01 pm #

    @Eric: Your questions are anything but naive: they are actually very sophisticated. Will you “always get a better return on the bond side with a longer duration”? Not necessarily. Usually the bond market offers a “term premium,” meaning simply that the longer the maturity, the greater the yield on the bond. But think of a simple example: Investor A buys a 30-year bond today at 4% and holds it to maturity. Investor B buys a 10-year bond at 2.5%, holds it to maturity, then buys another 10-year bond, holds that one to maturity and finally buys a third 10-year bond. Who will have the higher return of the full 30 years? We don;t know, because it depends what the rate on 10-year bonds is 10 years and 20 years from now, when Investor B renews his bonds.

    As for finding the “best value,” there is a bond strategy based on this idea. My colleague Justin Bender has written about it here:
    https://www.pwlcapital.com/en/Advisor/Toronto/Toronto-Team/Blog/Justin-Bender/July-2012/The-Variable-Maturity-Approach-to-Fixed-Income-Inv
    https://www.pwlcapital.com/en/Advisor/Toronto/Toronto-Team/Blog/Justin-Bender/September-2012/The-Variable-Maturity-Approach-to-Fixed-Income-%28Pa

  14. Eric July 11, 2015 at 9:59 am #

    Let me see if I understand this. Looking at part 1 of the post, after 1 year the 2 year bond is at a premium because although it now has a shorter duration (and therefore less risk) it still has the higher interest rate. You then monetize that premium at the end of the year. Then rinse and repeat. Is this equivalent to the yield curve shifting to the left by 1 year from the perspective of this 2 year bond after the first year? Sounds like free money so long as the yield curve holds constant? What are the implications if it doesn’t hold?

    Looking at part 2 of the post, one thing that hits me is that it is a binary switch between XSB and XBB. But getting back to my original question, would it make sense to have a continuous rather than binary mix of the two? This would vary the length of the bond between the extremes for XSB and XBB. Not sure if that makes sense or how one would go about computing that. I guess also through simulations?

    I also wonder about the 0.15% and 0.20% thresholds (we call them magic numbers in computer science). Is that based on a public research study or is it the companies own special sauce?

  15. Jake July 16, 2015 at 10:37 pm #

    How do the “experts” get and keep jobs in the financial business? After all the talk about rising interest rates from the “experts” there have been 2 rate cuts in a row. Seems like a great job to get in to just like meteorology, there’s no consequences to not doing your job !!!

  16. Brian G July 20, 2015 at 8:25 pm #

    @Jake, some things are not predictable with certainty. E.g. “interest rates will rise/fall by X date” is not predictable unless you have inside Bank of Canada information and can predict the market and economy.

    My own experience is that short term weather forecasts are much more accurate than any financial prediction given by any talking head in the media; so I wouldn’t put down meteorologists.

    Also, if anybody could actually forecast the future, why would they ever tell you or anybody? That would be massively valuable information. It makes no sense they would tell you or the world. Instead, they’d keep it to themselves and profit (massively) from it.

  17. Reena July 26, 2015 at 7:04 am #

    I think the best way for a beginner would be through an Exchange Traded Fund. Mutual Funds require thorough research because you are trying to evaluate the abilities of individuals to actively manage your portfolio. Rather than spend that time (and money through higher expense ratios), go with an ETF that will charge a tiny fee and give you broad exposure to the international markets. My recommendation would be to check out the iShares EAFE index fund (Ticker: EFA). It will provide you liquid, diversified exposure to Europe, Australia/New Zealand, and the Far East (Ex-Japan). If you have a bigger appetite for risk, you might also consider the emerging markets look at Ticker VWO from Vanguard or EEM from iShares.

  18. Bibi February 13, 2016 at 10:24 am #

    I have some cash that I will need in about 2 years. Does it still make sense to buy a short term bond index? If yes, is XSB a good candidate?
    Thanks

  19. Canadian Couch Potato February 13, 2016 at 3:22 pm #

    @Bibi: You can likely get a similar yield and no risk by using a savings account.

  20. Joon July 1, 2016 at 4:45 pm #

    Hi there,

    I’ve been following the Canadian Couch Potato model for aggressive, which puts VAB at 10%. I notice that Justin Bender’s blog (Canadian Portfolio Manager) the most aggressive model puts bonds at 30%. I understand (at a very basic level) two positive aspects of bonds (sometimes have excellent returns; are available to sell when equities dip) but am curious about the different philosophy re: percentage in bonds between your model and Justin’s. Thanks!

  21. Canadian Couch Potato July 3, 2016 at 7:58 pm #

    @Joon: In general, Justin’s model portfolios are closer to the range we use with our full-service clients. Our clients rarely use asset mixed that have less than 30% in bonds, usually because they tend to be older and their portfolios larger compared with the readers of my site. Don’t forget that one of the primary reasons to include bonds in a portfolio (in addition to the two you listed) is to reduce volatility, which is often a priority for investors who have less need to take equity risk.

  22. Joon July 3, 2016 at 11:25 pm #

    Thank you very much! 🙂

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