Using bonds for savings explained

Can you use bonds for savings? More specifically can you use an ETF of bonds for savings?

Because if you can life might just become a whole lot simpler.

Why?

One place for your money all the time.

You don’t have to keep looking around for the best savings rates.

You don’t have to worry that your bank is going to reduce your current rate after a year or whatever they’ve made you lock your money away for.

And on that note, you don’t have to lock your money away at all. Bond ETFs are easy to access.

Let’s get into it.

What are bonds?

When you buy a bond, you loan money to a company or the government.

This loan is for a fixed period of time. It can be months, years or decades but somewhere in the future there will be an agreed repayment date. At which point you’ll get all your money back.

To compensate you for your trouble, you’ll receive interest payments along the way. Usually every six months and this is the key way that you make money through bonds.

However, there is another way to make money through bonds and that’s during times of deflation.

Deflation effectively increases the value of money. You can essentially buy the same amount of stuff for less money than before.

It figures then, that bonds are often used in an investment portfolio as a hedge against deflation.

It also figures that if bonds are good in times of deflation they might not be quite as good in times of inflation.

And whilst that’s true to a certain extent, it doesn’t tell the whole story.

You see it depends.

Simply put, it depends on how long you are lending your money out for and this is important.

In fact, I’d go so far as to say that this is the key concept you need to understand with bonds.

It goes hand in hand with risk.

3D – The risks involved with bonds when used for savings

It is one of the risk characteristics of bonds which I like to call the three Ds or Bond 3D for short.

• D for Duration
• D for Default
• And D for Denomination

And it’s worth looking at each one of these in a bit more detail.

Duration

Strictly speaking duration means ‘the time during which something continues.’

However, when we are talking about bonds a more accurate description is this:

Duration is the measure of interest rate sensitivity on bond price

That sounds complicated when you say it out loud, but for us the relationship is simple.

The longer the duration the more sensitive to rate changes our bonds are.

What’s this sensitivity got to do with us you might well ask.

Well, it directly impacts the size of our savings balance.

In fact, for every 1% move in interest rates a bond’s price will move approximately 1% in the opposite direction multiplied by the duration.

Here’s an example to help explain that.

If I have a bond with a 1 year duration, a 1% move in interest rates is going to move the price by 1%. 2 year durations would move the price 2% and you’d get a 3% move on a three year duration.

You might be able to see where I’m going with this. Spoiler alert! It isn’t always pretty.

And that’s because interest rates can move up or down. If they move down, bond prices go up. However, if they move up, bond prices go downward.

For savings, I think it pays to focus on this second eventuality as this is where the risk lies.

Why do interest rates rising cause bond prices to fall?

Bonds can actually be bought and sold like shares. Imagine you bought a £100 bond that pays 3% only for interest rates to rise meaning new £100 bonds paid 5%.

Nobody’s going to pay £100 for your old bond when they can buy a new one for the same price that pays more. They’d only be willing to buy yours at a discount.

Of course this whole scenario could work in reverse, but as that’s a bonus, not a risk we’ll be ignoring that here.

Check out this graph. It shows the Bank of England base rate. Bond interest rates are based on this.

At the time of writing, rates have moved up about 5% over two years.

In December 2021 it was 0.1% but by August 2023 it was 5.25% (with no signs of stopping by the way). That’s a 5%+ increase.

Pretty unprecedented, very rare and unlikely to happen again any time soon, but certainly proves it can happen so you need to be prepared for it.

That’s because if it did happen again your balance could drop dramatically.

We are going to have a look at a table in a moment.

It shows three of the biggest UK bond funds. All by iShares and all UK government to keep things simple.

(For those in the know, the fact that the last one is indexed-linked shouldn’t impact the point we are trying to make here).

Buying individual bonds is a notoriously difficult thing to do and it comes with a small risk of its own. You are putting all your eggs in one basket.

On the other hand, buying bonds via exchange traded funds (ETFs) is a notoriously simple thing to do. You can read more about ETFs here, but the headline is this:

Anybody with an investment account can buy bond ETFs. They give you easy access to your money. You don’t have to lock it away and you spread it over multiple bonds so no individual bond risk (more on this under default below).

And the fact that individual bonds are continuously being bought and sold within a bond ETF means the expected investment returns are continuously updating.

The table also shows what a 5% rate increase would do to bond prices.

And finally, it shows what annual returns we currently expect to get in terms of yield to maturity (YTM) and the number of years it would take to get your money back based on that.

Using different duration bonds

ETF	Duration	Duration Years	What a 5% rate increase would do to bond prices	Expected investment / savings returns (Avg Yield to Maturity)	No. years to get your money back
iShares UK Gilts 0-5 years	Short	2	–10%	4.67%	2
iShares Core UK Gilts	Med	8	–40%	4.63%	9
iShares Index-Linked Gilts	Long	17	–85%	4.62%	18

Just in case you are wondering UK government bonds are called GILTs. This name is historical. UK government bond certificates issued by the British government used to come with gilded edges.

The key column to focus on is ‘what a 5% rate increase would do to bond prices.’

Hopefully you can see a simple relationship between duration and prices.

The longer the duration, the greater price drops you get when things move against you.

In other words, the longer the duration the greater the risk.

Minimising risk is usually pretty important when we are thinking about storing our cash for a rainy day.

In fact, I think it’s pretty clear from the table that medium and long-term bonds aren’t suitable for savings at all.

Don’t get me wrong. They are absolutely suitable for long term investment.

I mean, imagine what would happen if things went in reverse ie 85% increase in value in less than two years. I’d take that all day long. Over the long term we’d expect to claw any losses back (we are coming to this).

But the potential for an 85% drop in the short term in a savings account! I don’t think so.

Nobody wants to see big drops in their savings, particularly anything shorter term.

But short term bonds don’t drop anywhere near as much.

They look more like something we can work with.

Using short term bonds

The fact of the matter is duration risk associated with short term bonds is nothing like the other two.

And that’s because this actual 5% increase in rates we’ve just experienced caused one of the biggest if not the biggest bond market crash in history.

That’s how much of a big deal it was.

But even so, if there was a repeat, we would only expect it to cause our short bond ETF to loose 10% of its value. Even better, we would expect it to just take a couple of years to recover.

Another way of looking at that is this.

Whilst I’m no probability guru, I’m pretty sure another 5% rate hike ain’t happening any time soon. If for some crazy unforeseen reason it did, I’d then only expect to loose 10% of my money. Better still I could expect to recoup that more or less in full in a couple of years.

But that’s very very very unlikely to happen.

What’s more likely to happen is say a 1% rate increase which would produce a much smaller loss. And if that happened you could expect your yield to increase by a similar amount, so you’d recoup any loss much faster.

And yet another way of putting it is this.

Low duration bonds are very low risk. In fact they are so low risk that we can seriously think about using them as a savings vehicle.

Yield to maturity and investment returns

Another point worth mentioning before we move on is this. If you look carefully at those average yield to maturities (expected returns) in the table you can see that they are verging on identical.

Here they are again:

Investment returns on bonds

ETF	Duration	Duration Years	Avg Yield to Maturity
iShares UK Gilts 0-5 years	Short	2	4.67%
iShares Core UK Gilts	Med	8	4.63%
iShares Index-Linked Gilts	Long	17	4.62%

Such similar average yield to maturity (expected investment returns) is very unusual indeed.

In general, short-term bonds pay less than medium term and long bonds pay the most. The longer the duration the more you usually expect to get paid to compensate for this duration risk we’ve been talking about.

But obviously that’s not always the case. There are times when that doesn’t happen and we just happen to be living through one as I write this.

Due to the rapid increase in interest rates we have experienced recently we find ourselves in a very special situation.

There’s a whole industry of highly paid bond analysts out there that are getting their knickers in a twist over it.

But, I think all we need to know is this. It is likely to go back to normal soon and short term bonds look a great deal at the moment because you expect to get similar returns to longer bonds with less duration risk.

And you may also have noticed that these yield to maturities are higher than you are going to get on most savings accounts. Another key advantage.

Now for our next bond risk: Default.

Default

So we’ve already established bonds are a loan and like with any time you hand over your hard earned cash to somebody else, there is always a risk you won’t get your money back.

Bonds are no different.

Because we are going for a fund (ETF) we get rid of the default risk associated with investing in a single bond.

But that’s not where it ends.

We can actually do better than that.

That’s because, all things being equal, companies come with more risk than governments for the simple reason governments usually own the printing machines.

Equally, developed market governments are usually considered to be a safer bet than developing. Think US, Germany, Japan and of course Britain.

So for savings it is probably better to choose developed market government bonds.

Whether or not you choose those from the UK, will depend on your preferred denomination a.k.a. bond risk 3.

(FYI bonds have official credit ratings. This is a subject in itself but if you are interested you can read more on it here).

Denomination

I have to admit I’ve cheated with this one to keep everything beginning with D. If I’m totally honest it probably should say currency, but then again, as denomination and currency are two sides of the same coin I’m sticking with it.

People trade currencies and apparently make money doing so. I say apparently because I’ve only every heard of one person who used currency trading to get very rich and that’s George Soros. The fact that every other famous investor seems to do it via picking individual shares seems to me to suggest currency trading must be very difficult indeed.

In other words, we probably don’t want to be messing around with currencies in our savings account.

You want your bonds denominated in a currency you use, or at least will use in retirement. Anything else leaves you open to currency risk.

If I live in the UK, pay for everything in pounds but invest in US bonds for example, I take on currency risk.

If the dollar drops in value 20% against the pound I’ve essentially lost 20% of my money.

Again, not what we are looking for in a savings account.

Stick to the currency you use or will use when you start spending your money.

Using UK government bonds as your savings vehicle

So in a nutshell, whilst longer duration bond ETFs probably aren’t suitable for savings.

Shorter term is a different story.

I’d go so far as to say that somebody living in the UK could easily use a short term UK government bond ETF to handle a big chunk of their savings.

You may have other alternatives such as savings accounts but even then using bonds for savings does have its advantages. Namely:

• often higher returns
• don’t have to keep switching account to get the best interest rates
• don’t have to lock your money away
• available to just about anybody with an investment account

If you’ve read up to here, then well done. Bonds are a massive topic. There’s so much to unpack, you’d really need to read an entire book to fully get to grips with them.

But here’s the thing, most people who invest, have at least some of their money in bonds.

Similarly, most people’s pensions are packed full of bonds.

In other words, I’m pretty sure more people than not have some money in bonds without fully understanding them.

You don’t have to fully understand bonds to invest in them, have them in your pension or use them for savings.

Bond ETFs

As briefly mentioned above, the best way for most people to buy bonds is through buying shares in an ETF.

Here’s a quick summary of the advantages of doing that:

• Bond ETFs are easy to buy (individual bonds are tricky)
• You spread your money over multiple bonds (so you don’t put all your eggs in one basket)
• You don’t have to lock your money away
• Interest rates are constantly updating based on current interest rates (so you don’t have to keep moving your money about)
• Anybody with an investment account can buy bond ETFs.

It’s all good as far as I can see.

In fact, I think there’s only one problem. There are so many ETFs out there how do you choose which one is right for you?

How to choose bonds when using them for savings?

Based on what we have already covered, you should now know you need to be looking for short developed market government bonds in the right currency for you.

So for UK residents a short UK government bonds (GILTS) ETF makes most sense.

But there isn’t just one product out there.

For sure, our example, iShares UK Gilts 0-5 years ETF, is a great choice. That’s the one I use, but you may want to choose your own.

If you do, here are the key numbers you need to look for:

• Effective Duration
• Weighted Average Yield to Maturity (YTM)
• Base currency
• Total Expense Ratio TER (or Ongoing Charges Figure OCF)

You’ll find these on your ETF providers website.

It’s usually either clearly written somewhere or there will be a Fact Sheet that you can download which will include each of them.

Effective Duration

We’ve already covered duration in quite a bit of depth above but there are a couple of things to add.

Typically funds contain a basket of bonds of different durations. The effective duration is like a kind of average for the fund.

And for your information, I think it’s pretty much agreed that 5 years is the cut off for short bonds. 6 and above is considered to be mid-term.

Weighted Average Yield to Maturity (YTM)

The weighted average yield to maturity is about as close to a predicted investment return as you are going to get.

For short to mid duration high quality bonds such as those from the UK government we expect it to predict 90%+ of your investment returns.

Base currency

You want the base currency to be the currency you use now or will use when it’s time to start spending your money.

For most people living in the UK that’s going to be the pound.

But there are plenty of situations where that might not be the case. Here’s a few examples of the top of my head.

• You live abroad
• You plan on moving overseas and spending your money then
• You are saving for a holiday abroad

In each case the country in questions bonds could make more sense.

Total Expense Ratio TER (or Ongoing Charges Figure OCF)

The total Expense Ratio TER (or Ongoing Charges Figure OCF) is the annual fee you pay to the fund provider.

It is taken annually as a percentage of your balance.

The lower the better.

Fortunately for us, UK government bond ETFs usually have pretty low ongoing charges.

Have a look at those examples again.

Ongoing charges

ETF	TER/OCF
iShares UK Gilts 0-5 years	0.07%
iShares Core UK Gilts	0.07%
iShares Index-Linked Gilts	0.10%

The most expensive one from our samples is 0.10%. That’s pretty cheap. Here’s an example of how that pans out into what you pay.

If you had £10,000 in your account it would cost you £10/year.

Incidentally, I like to keep my ongoing charges below 0.3%.

Using bonds for savings – the bottom line

So there you have it.

Using bonds for savings is a thing.

They can make a perfect alternative to a savings account for expats, but even people living in the UK might want to take a look.

And that’s because it has a number of advantages over a standard savings account.

• often higher returns
• don’t have to keep switching account to get the best interest rates
• don’t have to lock your money away
• available to just about anybody with a savings account