While 10-Year Treasury yields have risen from 2.4% to 2.9% in 2018, the largest bond ETF TLT is down nearly 4% with yield 2.58%.
So why do I prefer bond ETF than term deposit? Why am I willing to accept short-term principal losses when interest rates rise?
First, let’s look at term deposit rate in US
You need to put 2 years term deposit to beat TLT. I look at
1. Liquidity and cost
If you don’t hold a term deposit to maturity, you will have to pay a penalty to get your money back, often 3 months’ worth of interest but can be higher depending on the bank/maturity.
With a no transaction fee bond mutual fund, you can sell at the end of each day with no penalty and with a bond ETF you can sell intra-day less only the cost of commission (which can be free if it is a commission-free ETF at your broker).
2. Personal Effort
A term deposit requires effort in finding the bank with the best interest rate, opening up a new account. When a term deposit comes due, many have the option to automatically renew at the same term at whatever the latest rate is, but if you want to shop for a higher rate, you will have to repeat this process all over again.
By comparison, the effort in purchasing bond ETFs is minimal and requires virtually no maintenance.
3. Taxes
If you are Taiwanese without US citizenship, your interest income will be subject to 30% tax rate, however, your capital gain tax is usually exempt.
4. Interest Rate Risk
If interest rates rise, you may be locked into a lower yielding CD. While there are “bump-up” CDs that give you the option of moving interest rates up (typically once) during a term, they often come with lower starting yields.
During a period of rising rates, bond funds are constantly reinvesting principal and interest into higher yielding securities, but at the same time they incur price declines on their existing bond holdings.
Whether a term deposit is better for an investor than an bond ETF will depend on a multitude of factors, many of which cannot be predicted in advance (most importantly, the direction of interest rates). What we can say with confidence is that for investors with little tolerance for drawdowns in the low-risk bond portion of their portfolio, term deposit may be worthy of consideration.
The investment strategy you can stick with is often the best strategy.
So why do I prefer bond ETF than term deposit? Why am I willing to accept short-term principal losses when interest rates rise?
First, let’s look at term deposit rate in US
You need to put 2 years term deposit to beat TLT. I look at
1. Liquidity and cost
If you don’t hold a term deposit to maturity, you will have to pay a penalty to get your money back, often 3 months’ worth of interest but can be higher depending on the bank/maturity.
With a no transaction fee bond mutual fund, you can sell at the end of each day with no penalty and with a bond ETF you can sell intra-day less only the cost of commission (which can be free if it is a commission-free ETF at your broker).
2. Personal Effort
A term deposit requires effort in finding the bank with the best interest rate, opening up a new account. When a term deposit comes due, many have the option to automatically renew at the same term at whatever the latest rate is, but if you want to shop for a higher rate, you will have to repeat this process all over again.
By comparison, the effort in purchasing bond ETFs is minimal and requires virtually no maintenance.
3. Taxes
If you are Taiwanese without US citizenship, your interest income will be subject to 30% tax rate, however, your capital gain tax is usually exempt.
4. Interest Rate Risk
If interest rates rise, you may be locked into a lower yielding CD. While there are “bump-up” CDs that give you the option of moving interest rates up (typically once) during a term, they often come with lower starting yields.
During a period of rising rates, bond funds are constantly reinvesting principal and interest into higher yielding securities, but at the same time they incur price declines on their existing bond holdings.
Whether a term deposit is better for an investor than an bond ETF will depend on a multitude of factors, many of which cannot be predicted in advance (most importantly, the direction of interest rates). What we can say with confidence is that for investors with little tolerance for drawdowns in the low-risk bond portion of their portfolio, term deposit may be worthy of consideration.
The investment strategy you can stick with is often the best strategy.
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