Everyone needs a corner of their savings or investment portfolio that needs to be safe.
Sure, equities, like stocks, are the preferred way to invest and grow your money over the long term.
But stocks can both rise and fall in value.
Having a certain amount of money set aside that isn’t invested in equities is a good way to stabilize your portfolio. It means not having all of your financial assets exposed to risk.
As well, it’s always important to have a certain percentage of your financial assets sitting someplace safe, and where you can easily get the money if the need arises.
Savings accounts and bond funds, both mutual funds and exchange-traded funds (ETFs), are two of the most popular ways to accomplish those goals. But which is the better choice?
Online Savings Accounts
Savings accounts are held at banks and provide easy access to your funds.
Banks pay interest on your savings, though the rates paid by the vast majority of traditional banks are microscopic.
By contrast, some savings accounts at online banks can pay 100x what you get at a brick and mortar bank.
By keeping your savings in a high-yield online savings account, you not only get easy access to your funds, but you earn interest that’s well above what you can get at your local bank.
This is a critical component of any cash related investment. Your funds should be completely safe. Savings accounts accomplish this goal in two ways:
When you invest money in a savings account, the principal balance is always 100% guaranteed by the bank.
If you invest $10,000 today, you’ll still have $10,000 – plus interest earned – in five years. Savings accounts are not subject to fluctuations in market value.
All savings accounts are covered by FDIC insurance.
This is a federal agency that protects bank deposits for up to $250,000 per depositor, per bank (if your savings will exceed that limit, you can simply open an account with another bank).
FDIC insurance protects the depositor from factors that would cause the depositor to lose money on their savings, including default by the bank.
The combination of the two means that money held in savings accounts are 100% safe.
Liquidity and accessibility
Savings accounts are second only to checking accounts in liquidity and accessibility.
You can generally withdraw money at any time, and for any amount.
One of the main differences between savings and checking accounts is that you are generally limited to no more than six withdrawals per month with a savings account, while you have unlimited withdrawals with checking accounts.
However, savings funds can easily be transferred to another account, such as a checking account, through online banking. Many savings accounts also come with ATM cards, that allow you to access your money at literally thousands of ATM machines.
Some even offer mobile payment systems like Zelle. These enable you to transfer money to third parties instantaneously through a smartphone or by email.
Bond Funds & ETFs
Bond funds and ETF’s represent portfolios of many different bond securities.
A single fund can hold hundreds of different bonds. Each fund is managed by a professional bond fund manager, who creates and maintains the fund consistent with its stated investment objectives.
Funds can be segregated by specific bond types. Examples of the different types of bond funds available include:
- High-grade corporate bonds
- High-yield corporate bonds (lower quality bonds paying higher interest)
- U.S. government bonds
- Foreign government and corporate bonds
- Municipal bonds
- Mortgage bonds
Some bond funds may contain a mix of some or all of the above bond types.
And since bonds typically run in terms ranging from 15 to 30 years, you can also get funds based on terms.
For example, you can invest in a fund that holds long-term bonds, or limits remaining maturities to no more than 1 to 3 years.
The advantage of investing in bond funds, rather than in individual bonds, is that they allow you to spread your money across many different bonds, rather than just one or two.
That provides greater protection against default by any particular bond issuer.
Bond mutual funds vs. bond ETFs
Bond mutual funds are typically actively managed funds.
That is, the fund attempts to outperform the general bond market.
The fund manager searches the market for specific bond issues he or she believes will be the best performers. They will perform a credit analysis on each issue, to make sure it’s acceptable for the fund.
Bond mutual funds often charge what are known as “load” fees, or simply loads (see “Cost to Own Bond Funds” below).
By contrast, ETF’s function as index funds, rather than as actively managed funds (some bond mutual funds are also index funds).
With an index fund, you’re merely seeking to match the underlying benchmark – not to outperform it.
The ETF fund manager will create a fund portfolio that will match that of the underlying index it is based on. In addition, ETF’s don’t charge load fees.
And while mutual funds are purchased through various fund families, ETF’s are listed on the stock exchange and can be purchased directly.
Bond funds and capital preservation
Bonds are generally considered safer than stocks, particularly if they’re of the short-term variety. However, neither bonds nor bond funds are 100% safe.
Even within a bond fund, individual bond issues held can be defaulted on by the issuer. That would cause the value of your fund to fall slightly.
But an even bigger risk to bond funds is what is known as interest rate risk.
Bonds, because they are long-term in nature, have an inverse relationship with interest rates. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
If you’re holding a bond fund, and interest rates begin rising, the market value of the bonds within the fund will fall so that yields are more consistent with current rates. Bond principal will still be paid in full upon maturity, but losses can be realized on early sales.
Bonds funds do have some insurance coverage through the Securities Investors Protection Corporation, or SIPC.
However, this coverage applies to the brokerage account bond funds are held through, protecting the investor from broker default.
The coverage does not apply specifically to the bond fund, or the bonds within the fund. The coverage provides investors with insurance of up to $500,000 of loss due to broker failure.
Liquidity and accessibility
Bond funds are fairly liquid, but not nearly as much as savings accounts. If you need to cash out your bond fund, you’ll first need to sell the fund through your broker.
Depending on the type of fund you have, and market conditions, the sale may not be completed until the end of the business day.
And once the sale is complete, you will then have to transfer the proceeds to a bank account, which can take up to 7 days to complete. This is comparable to the process of selling stocks or stock funds through a brokerage account.
As well, the proceeds from the sale of a bond fund may be reduced by certain fees (see below).
Cost to own
Since they are securities, bond funds do involve certain transaction costs and other expenses. Those include:
These are sales fees that apply to bond mutual funds, but not ETF’s. Not all mutual funds charge loads, but of those who do the range is typically between 1% and 3% of the fund value.
The load may be charged upfront, upon sale, or both.
For example, a bond mutual fund may charge a 2% load on purchase, and 1% on sale. The back end charge is sometimes waived if you hold the fund for a certain minimum amount of time, like two years.
If you’re purchasing or selling bond funds through a broker, you will generally be charged a commission on both the purchase and sale.
A broker may charge $6.95 to buy and sell an ETF, and as much as $50 to buy and sell a bond mutual fund.
These are fees to cover marketing and distribution on the fund. It’s included in what is known as a fund’s expense ratio. 12b-1 fees range between 0.25% and 1% of a fund’s net assets.
It is deducted from the fund’s net income, and therefore an indirect charge to the investor.
Which is Better?
Though both savings accounts and bond funds and ETF’s focus primarily on capital preservation, they each do it in a different way.
Savings accounts are primarily designed for shorter-term savings. They’re completely liquid, interest-bearing, and can be accessed at any time.
That makes them perfect for emergency funds, or for saving money for a specific purpose, like the down payment on a house.
Bond funds and ETF’s are primarily capital preservation within an investment portfolio.
They work as a diversification against the higher risk of equity investments, like stocks.
They tend to work better as long-term investments than savings accounts because they can pay much higher interest rates.
They can also represent something of a speculative investment. The same interest rate risk that can cause the value of bonds to decline in the face of rising interest rates, can also cause bond prices to rise if rates fall.
If you believe rates will fall, bond funds and ETF’s can be an excellent way to play that trend.
Savings accounts and bond funds and ETF’s aren’t an either/or consideration.
As an investor, you should plan to have both. Savings accounts should function as a short-term, interest-bearing cushion that you can access as needed, or to save for a specific spending purpose.
Bond funds and ETF’s provide a diversification in a well-balanced investment portfolio.
Each serves a related, but unique purpose, and has a place in your financial asset mix.