Are bond index funds a safe way to save for a mortgage down payment?

Question

I came across Betterment's "Smart Saver" account today, which is a savings-account alternative that invests in U.S. Treasury bonds and low-volatility corporate bonds. The APY is almost exactly the same as my savings account that I have at Ally. The only main difference is that the interest earned in this Smart Saver account is not subject to state income taxes, but it also is not FDIC/NCUA insured. This got me thinking about using bonds as an alternative to a savings account.

I will probably buy a house in the next 5 years or so. This length of time is still too short to invest in stocks, so I won't do that. But, I looked at some of Schwab's commission-free bond ETFs and most of the returns are well above my savings account, even when you factor in the expense ratios. They also seem to have a relatively low amount of volatility (from what my inexperienced eye can tell).

Here are my questions:

• Given several years to save for a down payment, are bonds or bond ETFs a smart way to save for a little more % APY? (As opposed to a simple high-yield savings account).
• What other performance indicators should be used when evaluating bond ETFs?
• Assuming there is another recession in the next few years, how would it affect bonds and bond ETFs? And would that be different for government vs. corporate bonds?
• Would it be better to simply buy the bonds myself? What advantage does using a bond ETF give?

Answer 1

Bonds are great because you get that guaranteed return, ignoring defaults. You buy $1,000 of tomorrow money for $990 today. Bond funds, are different. Bond funds constantly transact bonds within certain risk and duration profiles and bond values have an inverse correlation to interest rates. If interest rates fall the principle value of your holdings in the fund increases, your $990 becomes $991. But, if interest rates increase, the principle value of your fund decreases, your $990 becomes $989. If you were just holding a bond, you could simply hold to maturity and collect your $1,000 in the future. With a fund you have no such option to hold to maturity.

Fund yields are a lot different than published interest rates for savings accounts. The $990 you put in a savings account is guaranteed at $990. The $990 you invest in a bond fund might be $980 tomorrow. The $990 you spend buying a $1,000 treasury might fluctuate during your holding period, but you're definitely getting your $1,000 at maturity.

While bond funds might experience less volatility than equity markets, they have infinity more volatility than your savings account.

Answer 2

It's possible to have both inflation and recession at the same time. That's stagflation and based on a large supply of longer-term bonds being issued at the same time as a slowing economy.

In other words the short-term interest rate is a government rate while longer-term interest rates are market rates. If long-term rates go up then long-term bonds drop in price.

The current price rise in bonds is impressive but it could unwind if the budget deficit were to become a problem.

So a five year plan should be buying bonds that redeem in five years.

A mutual fund or an ETF has a duration that can be looked up. But individual bonds can be continuously aimed to the same target redemption date as they are continuously bought. A Treasury Direct account can easily produce an ongoing bond portfolio. Or bonds can be bought in a brokerage account.

Or go aggressive to maximize income to set against bond valuations. Closed-end funds, for instance, use both leverage and hedging with bond funds.

Answer 3

Before narrowing down to asset classes and products within an asset class (i.e. being swayed by marketing), try to be more specific about your liquidity requirements and your downside risk tolerance.

• What percentage of your downpayment savings can you afford to lose before it knocks you out of contention for the price level of house that you hope to buy?
• Assuming the the time between finding a house you want to buy and closing is at most three months, do you really need less than three months' duration for your down payment savings over the next five years? Can you lock the funds up for, say, a year before moving to shorter duration?

Knowing your risk and liquidity profile means that you can more easily choose asset classes, and products therein, based on how they fit your profile. A crude example is below. Your advisor (robo- or not) should have something more sophisticated available.

The way you have posed your questions suggests that you are looking to invest the amount intended for downpayment in a single asset (class) rather than diversifying. In that case you will care about downside risk the most. That could mean ignoring the marketing pitches about potential investment return and sticking to the safest investments that meet your liquidity requirements. Following this reasoning:

Given several years to save for a down payment, are bonds or bond ETFs a smart way to save for a little more % APY? (As opposed to a simple high-yield savings account).

ETFs give you liquidity you don't need right away at the cost of management fees and relatively less certain returns compared with either mutual funds or outright purchases of safe bonds. Yields on funds and ETFs are not directly comparable to savings products where you have limited risk of capital loss, so don't be swayed into thinking that higher yield is always better.

What other performance indicators should be used when evaluating bond ETFs?

For any investment, look at return volatility. It is always backward-looking but that is typically what investment managers target for retail products (as opposed to attempting to achieve X% return and damn the volatility).

Assuming there is another recession in the next few years, how would it affect bonds and bond ETFs? And would that be different for government vs. corporate bonds?

Read the risk factors from some prospectuses. Corporate bond defaults tend to be positively correlated with recessions. Nominal bond yields tend to be positively correlated with inflation; that relationship is sensitive to the proportion of the yield compensating the holder for credit risk.

Would it be better to simply buy the bonds myself?

There are distinct advantages to letting a professional do it for you. Bond index funds exist for that reason.

What advantage does using a bond ETF give?

Liquidity. While they are liquid... but I digress. Read What are the important differences between mutual funds and Exchange Traded Funds (ETFs)?

Answer 4

My financial advisor said to keep 5 yrs of cash in my bucket. That means anything I need within 5 yrs for any reason should not be invested in anything except short term, such as a CD. You can find higher CD rates at bankrate.com. if you need that money in 5 yrs, keep it out of the market.