Are You Brave Enough To Put Your Cash In Bonds?

(photo: iStockphoto)

It’s time for another episode of everyone’s favorite investing game show, Where Should I Put My Cash?

First, a review of the ground rules. Money market mutual funds are currently yielding 0.04%, according to iMoneyNet.com. The average savings account, according to Bankrate, yields 0.69%. The best online savings accounts? About 1.3%. All of these rates sound suspiciously close to what a mattress pays (although that’s deceptive, since inflation is close to zero as well).

In past installments of the show, I’ve looked at:

• Reward checking accounts
• Long-term CDs
• Betterment.com, a streamlined stock/bond portfolio

Today, let’s look at bond funds. Should you keep your cash in one?

The short answer: probably not. The long answer: well, it’s a pretty long answer.

An avalanche of cash

Believe me, we’re not the only ones looking at bond funds. According to the Investment Company Institute, investors sunk an astonishing $185.6 billion into bond funds between January and the end of July. Where did all that money come from? Not from stocks: over the same period, investors pulled “only” $1.68 billion out of stock funds.

Instead, it came from money market funds. Surprise, surprise: investors were tired of earning 0.0%. But a bond fund is not the same thing as a money market fund, and it’s worth investigating what you can expect from a bond fund and how to stay safe.

Bond funds come in many flavors, because bonds come in many flavors. (Dibs on chocolate.) You can buy a treasury bond fund in your choice of short-term, medium-term, long-term, or inflation-protected. You can buy a corporate or mortgage-backed bond fund, a fund full of junk bonds or tax-free municipal bonds.

This is starting to sound like a showtune, and jaunty musical numbers are not my style, so let’s focus. If you’re looking for a safe place for cash, treasury bonds are going to be what comes to mind—and not just your mind, since a lust for safety has driven treasury bond yields to historic lows.

For the bond fund investor looking for more yield, that’s a problem. If you want more return, “You can go down in credit quality, or you can go out in maturity,” says Carl Richards, who writes about personal finance (and does cool napkin sketches) for the Bucks blog at New York Times. “You can replace ‘yield’ with ‘risk. So if you say ‘high-yield fund,’ you mean ‘high-risk fund.’”

Risky biscuits

Yes, that means a bond fund full of nothing but “totally safe” treasury bonds has risk. The main risk is rising interest rates. When interest rates go up, bond values go down, and vice versa. (Richards has a napkin illustrating this principle.) Your bond fund has a single number (available by looking up the ticker symbol on, say, Google Finance) that tells you how sensitive it is to interest rates: the average duration.

Chris Philips, a bond analyst at Vanguard, says this simple relationship between interest rates and duration overstates the risk of bond funds. “Rising interest rates don’t have to mean negative returns for an investor in bonds,” he says. He points to the post-dot-com bubble days in the early 2000s. The Federal Reserve raised interest rates several points over a period of several years. However, “it was a very systematic, very well-communicated increase in interest rates,” and Vanguard’s short- and intermediate-term treasury funds did fine. The higher interest payments per share more than compensated for the loss in share price.

Richards is unconvinced. “You have no idea whether the Federal Reserve is going to give signals or how rates are going to go up. The only thing we know is that we don’t know.” He’s not saying bond funds are as risky as stock funds, but he considers them an inappropriate vehicle for cash. “Just buy high-quality short-term bond funds. Their only purpose is to allow you to sleep at night while your stocks grow.”

I asked Richards where he keeps his cash. “In the backyard,” he laughed. Actually, he uses an online money market deposit account. But let’s all go dig up his backyard, just in case.

Cash-only lane

Low interest rates drive investors a little mad. We divide our money into two buckets—the cash and the portfolio—and then we get jittery if the cash doesn’t seem to be bringing us regular gifts in the form of sweet, buttery interest payments.

We forget—and as the guy who put most of his emergency fund into a CD two weeks ago, I’m as guilty as anyone—that the whole point of cash is that we can lean on it in hard times, like the shoulder of an old friend. If your friend says, “Sorry, I can’t come over, I’m washing my hair,” that is one thing. When Benjamin Franklin says it, it’s even worse.

In other words, it’s okay for your cash to lie around like a cat on the sofa arm. Sure, go for that 1.25% online savings account or low-penalty CD instead of the 0% money market fund. But your cash should hang in there in both rising and falling interest-rate environments.

Bond funds are a vital part of an investment portfolio. As a parking spot for cash, however, they’re not worth the risk. As Richards put it, “People think that this is a money-market replacement, and they’re going to get whacked.”