Bond index fund vs savings account

btcp

While paying lower interest than equity funds, bonds fund identified as a low risk investment. Does it mean they are a good alternative to savings accounts that pay almost nothing? I used to have Santander 123 but the interest is so low so I am wondering where to put my 20k+ emergency fund and don’t lose much. 

I was looking at historical data for global bond index at Vanguard, and there were a couple of years when the fund was in a negative 1% so this is not much in comparison to other years where the interest was above 2-3%. So provided I am willing to accept a risk of losing 1% in case of a need for emergency sell, am I missing anything else? 

Alexland

Provided interest rates keep going down you should be fine. If they start going up you could see why they carry investment risk as you get stuck with a load of bonds you overpaid for which are now worth less.

Linton

Alexland said:

Provided interest rates keep going down you should be fine. If they start going up you could see why they carry investment risk as you get stuck with a load of bonds you overpaid for which are now worth less.

Very true, but since they are currently more or less at zero........

btcp said:

While paying lower interest than equity funds, bonds fund identified as a low risk investment. Does it mean they are a good alternative to savings accounts that pay almost nothing? I used to have Santander 123 but the interest is so low so I am wondering where to put my 20k+ emergency fund and don’t lose much. 

I was looking at historical data for global bond index at Vanguard, and there were a couple of years when the fund was in a negative 1% so this is not much in comparison to other years where the interest was above 2-3%. So provided I am willing to accept a risk of losing 1% in case of a need for emergency sell, am I missing anything else? 

The possible loss with a bond fund is much more than 1%.  Almost all gilts maturing in the next 5 years are showing negative returns in £ terms.  The total interest plus return of capital is less than the current price.

Prism

If you dig a little deeper into Vanguards Global bond fund you will find it is currency hedged which means it likely won't move much with currency variations. It has an effective duration of 7.5% which means that a 1% global increase in interest rates would drop the value of the fund by around 7.5%. Meanwhile it currently pays out around 1.6% per year in dividends.

btcp

Thank you, looks a bit more complex than I thought. Letting emergency money sit without any interest could be a better option. 

Another_Saver

Prism said:

If you dig a little deeper into Vanguards Global bond fund you will find it is currency hedged which means it likely won't move much with currency variations. It has an effective duration of 7.5% which means that a 1% global increase in interest rates would drop the value of the fund by around 7.5%. Meanwhile it currently pays out around 1.6% per year in dividends.

The distributions tab of the fund page is not reliable, use the yield to maturity on the portfolio data tab (on iShares it's portfolio characteristics)
The yield to maturity is 0.7% to 1dp (an iShares equivalent shows 0.80% to 2dp, the Vanguard funds total fees come to 0.44% on the vanguard platform) so the actual return you'll get over the next 9.2 years (maturity) is at most 0.36% annualised before any credit defaults.
So no, not a good cash substitute.

Alexland

Linton said:

Very true, but since they are currently more or less at zero........

Exactly they are almost offering a return-free risk. Mathematically not much more to pull forwards now. Shop around for the best rates on emergency money.

masonic

Alexland said:

Linton said:

Very true, but since they are currently more or less at zero........

Exactly they are almost offering a return-free risk. Mathematically not much more to pull forwards now. Shop around for the best rates on emergency money.

It's a dilemma that doesn't just affect those looking for ways to improve the returns on their emergency cash. I'm holding rather more cash than I need to as a substitute for bonds, but I've been loath to sell up the bond funds I hold in order to sit on the cash. There will surely come a period where returns must turn negative for a protracted period.

barnstar2077

Could something like Vanguards Lifestrategy 20 or VLS 40 be a possible solution?  Yes it would fall a bit more in a downturn, but you would gain more growth in the upturns which would help to offset the risk of just holding bonds?

masonic

barnstar2077 said:

Could something like Vanguards Lifestrategy 20 or VLS 40 be a possible solution?

Holding 20% equities and 80% bonds gives better risk adjusted returns over the long term than holding 100% bonds, and this would be true in a rising interest rate environment. There must be very few individuals whose risk tolerance allows them to invest in 100% bonds, but not VLS20.

If you are holding a mixture of equities and bonds, then you can achieve a, say, 70% equities portfolio by either holding 70% equities funds and 30% bond funds, or about 64% equities funds and 36% VLS20, or about 68% equities and 32% VLS40. That would keep you neutral in risk. If you wanted to increase your risk slightly, then you could ignore the equities in the defensive funds and stick to a 70:30 ratio, but this would only reduce your bond holdings by a few percent. The specific risk of interest rates rising will generally negatively impact equities as well as bonds, so, other than a higher return for taking more risk, I'm not seeing a specific benefit to including a mixed asset fund vs separate equity and bond funds, or substituting cash for a fund that is predominantly bonds in a situation where you wouldn't otherwise be investing in equities at all.

Of course the problem can be skillfully avoided by going 100% equities and this would also give you the highest long term return expectation, but of course also considerably higher risk.

barnstar2077

I just thought that holding a small amount of equity would allow you to build up a bit of a buffer for when interest rates do eventually start to rise, which would then mean you could get your money out before you have taken any real loss (because any small drop would be taken out of the buffer you have built up.)

I'm not saying anyone should do it, it's just an idea.