Are Bonds a Better Place for Cash Than Your Savings Account?

With savings accounts paying next to nothing, it might seem like a smart idea to put your emergency savings and uninvested cash in bonds instead to try to get a decent return. But in this Fool Live video clip, recorded on August 9, Fool.com contributor Matt Frankel, CFP, and Industry Focus host Jason Moser discuss what investors should keep in mind before doing so. 

Jason Moser: Matt, we got a question on Twitter the other day from Matt Bayer, @MattBayer asks, "Thoughts on municipal bond funds as a pretty safe place to store some cash for a year while making a bit of return." We get questions like this in some form or another fairly often. Folks looking for a way to squeeze some type of return out of the cash that they have across a shorter timeline. Typically we say if you have money that you know you're going to need within the next three years or less, you really should be thinking long and hard before you invest that in the market. Because you can put yourself in a situation where you become a desperate seller. Nobody wants to do that. Obviously, bonds, a little bit of a different dynamic to bonds as opposed to the stock market. I'm wondering if you had any insight here, particularly given your Certified Financial Planner status.

Matt Frankel: I don't want to just answer this from the municipal bonds angle. They have their own benefits, specifically that they're tax-free. You don't have to pay tax on the interest you get. But a lot of people think bonds are a better investment right now than just leaving some of your money in cash. There's some logic to that to be fair. I don't know what your savings account's paying right now, but I'm not 100% sure mine's paying anything.

Moser: I was going to say it may not be paying anything at all, but it's possible I saw something like a nickel worth of interest the other month, I think.

Frankel: It's nothing.

Moser: No, it's not reportable.

Frankel: Bonds are not paying a ton right now, but there are paying a lot more than 0.01% that some savings accounts are paying. It's a natural place for investors might want to put it. What I will say about bonds is that that's good logic, if you're going to buy a bond and hold it to maturity. For example, if I buy a 10-year Treasury bond paying 1.5% and hold it until it expires in 10 years. I'm going to get those 1.5% interest payments semiannually for the next 10 years, and at the end of the term, I'll get my money back. On a shorter-term basis, bond valuations do fluctuate. If you look at a chart of any municipal bond fund or Treasury bond fund, I'm looking at the Vanguard Total Bond Index Fund (BND 0.51%) is one of my favorites. Ticker symbol is BND, that's what I'm looking at right now as I'm talking. The chart fluctuates, things aren't completely stable investments. The benefit to a savings account is it if I put $100 in a savings account, in six months that's going to be worth $100 roughly.

Moser: Yeah.

Frankel: If I put $100 into a bond fund, it's not going to fluctuate tremendously, but it could be worth $98, $96, $102. It's not just the interest you're getting because the value of those bonds that the fund holds fluctuate over time, and the reason they fluctuate overtime, the primary reason, is interest rates. I don't want to get too mathematical or technical here, but the key point to note is that bond values and interest rates have an inverse relationship. If Treasury yields spike, the value of existing bonds goes down. If Treasury yields fall, the value of existing bonds go up. Treasuries and most funds are paying historically low interest rates right now. There's a little room to the downside and a lot of room for interest rates to rise. As interest rates rise, let's say that the economy overheats, the Fed has to raise rates and the 10-year Treasury yield spikes to 3%. That would push the value of your bond funds down, so it's not as risk-free of an investment as you might think. It's a lot lower risk than putting your money in the stock market. But as compared to putting it in a savings account right now, that bond fund I mentioned pays just under 2 percent dividend yield or interest rather. You're not getting that for free, you're taking on a little bit of risk to get that. There's no such thing as risk-free returns right now. That's a popular economic concept is risk-free returns.

Moser: Yeah.

Frankel: And at normal times you can get that by buying like a three-month Treasury, which right now pays like nothing.

Moser: Take a risk getting out of bed in the morning, right, Matt?

Frankel: Right. If you're buying any type of municipal bond fund, unless it's very short term, which probably doesn't some pay much, you are taking some risk to your principal as interest rates fluctuate. That bond fund I mentioned, the share price has fluctuated over the past year between about $84 a share at about $88 a share.

Moser: Oh, wow.

Frankel: Not a ton of volatility when you think about some of the stocks we follow.

Moser: Yeah, but it's still there.

Frankel: The price isn't going to double, but there is risk.

Moser: Yeah.

Frankel: I mean, that's volatility, so it's more volatile than a savings account, which is what you need to know going in.