We’ve all seen clients who have stunningly large portions of their wealth in checking or savings accounts. And their reasoning is almost always the same: “I don’t trust the stock market, I think it’s headed for a fall.”
This is where financial advisors come in. It’s crucial that we explain the importance of long-term wealth creation through investing, whether in stocks or bonds. And we follow that up with the common sense view that you simply can’t time the market.
Still, for clients who have a clear risk aversion, a conservative portfolio is a better plan than no portfolio at all. Moreover, capital preservation becomes a primary concern for clients who are within five years of retirement. And that’s where short-term bond funds come in. These ETFs can produce moderate income streams while seeing little fluctuation in their value.
Vanguard, for example, offers three short-term bond funds with a combined $85 billion in assets. All have a 0.07 percent expense ratio. Is there any major difference between the Vanguard Short-Term Corporate Bond ETF (VCSH), Vanguard Short-Term Bond ETF (BSV) and the Vanguard Short-Term Treasury ETF (VGSH)?
As you’d suspect, the corporate bond ETF offers the highest payout, with a current 30-day SEC yield of 3.01 percent. That’s the premium built in for any perceived default risk. Yet we’re talking about investment-grade bonds, which rarely default. According to Standard & Poor's, investment-grade bonds default at an average annual rate of 0.10 percent. And when you consider this fund owns more than 2,000 bonds, a default or two doesn’t deliver much pain.
The BSV fund sports a 2.51 percent 30-day SEC yield. But it can be more volatile than a truly short-term focused bond fund because it owns bonds that carry maturities of up to five years. The VGSH fund, which avoids bonds with maturities exceeding three years, accounts for that trade-off by offering a slightly lower 2.33 percent 30-day SEC yield.
Of course, right about now, your savvy client is interrupting you by noting that a one-year certificate of deposit currently offers a 2.85 percent yield, according to Bankrate.com. So why own a bond fund with a potentially smaller yield?
The answer is simple. Unlike CDs, a bond fund can be cashed in at a moment’s notice, which might come in handy if a client needs fast cash. Also, in the face of a major stock market pullback, that kind of flexibility can help clients pivot back to equities after stock valuations have fallen.
The Active Hand
While passively-managed ETFs are the predominant approach among equity funds, the active approach seems better suited for fixed-income funds. Fidelity Investments looked at Morningstar data in 2017 and found that more than 85 percent of actively-managed fixed-income funds beat their benchmarks after expenses on a one-year time frame. Spotting pricing opportunities among the thousands of tradable bonds is a clear value add.