Bond Funds vs Money Market Funds

Low risk investors must pay attention to their potential returns, but also the safety of their investments. Two popular low-risk investment options are bond funds and money market funds. In this blog post, we’ll explore the key features of both and help you determine which might be more suitable for your investment strategy.

What are Bond Funds?

Bonds are debt securities issued by entities such as governments, municipalities, or corporations to raise capital. When you buy a bond, you are essentially lending money to the issuer in exchange for regular interest payments and the return of the principal amount when the bond reaches its maturity date.

Bond funds are diversified investment portfolios consisting of different types of bonds. They’re most suitable for investors seeking income generation while taking on relatively low risk.

Bond prices are sensitive to interest rates. Bonds are also inversely correlated to rates, which means than when rates go up, bonds go down.

Taxes: The interest received from bonds is taxed at the investor’s highest marginal rate. This makes interest worse than dividend income. But, when bond funds buy & sell securities prior to maturity, they may also incur capital gains (or losses).

Key Factors to consider when choosing a bond fund:

• Management Expense Ratio (MER): This is the fee charged by the fund manager for managing the portfolio. Lower fees can lead to higher returns over time.
• Duration or average term to maturity: This is an indicator of how sensitive the fund is to interest rate changes. A longer duration means more sensitivity to interest rate fluctuations.
• Yield to maturity: This is the expected annualized return on the bond fund if held until maturity, considering interest payments and capital gains or losses.

Active vs Passive Funds:

Bond funds can be either active or passive. Passive funds follow an indexing approach, replicating the performance of a bond index, and generally have lower fees. Active funds take a tactical approach and may outperform or underperform the index. They typically have higher fees. Your choice depends on your investing style and risk tolerance.

What are Money Market Funds?

Money market funds are low-risk investment vehicles that invest in high-quality, short-term debt instruments, such as Treasury bills, commercial paper, or certificates of deposit. They are most suitable for investors seeking principal protection as their primary concern.

Taxes: The interest earned from money market funds is generally subject to income tax at the investor’s highest marginal rate. However, unlike bond funds, money market funds will not incur capital gains or losses.

Bond Funds vs Money Market Funds:

Fluctuation in value: Bond fund values fluctuate with market conditions, and their value may decline when interest rates rise. In contrast, money market funds aim to maintain a stable net asset value (NAV) and do not fluctuate with interest rates.

Principal protection: Money market funds focus on preserving the investor’s principal and are more suitable for investors with principal protection as their primary goal.

Interest rates and yield curve: When the yield curve is upwardly sloped, bond funds tend to earn higher interest rates due to their longer-term maturities. This can lead to higher income generation compared to money market funds.

Comparing Canadian Bond Funds

Fund Name	MER	Style
CIBC Canadian Bond Fund Premium Class	0.60%	Active
TD Canadian Bond Fund Premium D Class	0.67%	Active
BMO Aggregate Bond Index ETF	0.08%	Passive
iShares Core Canadian Universe Bond Index ETF	0.10%	Passive
Vanguard Canadian Aggregate Bond Index ETF	0.09%	Passive

As the table above shows, actively managed funds have higher fees compared to passive funds. In a low rate environment, these fees will have an even bigger impact on returns. At the time of writing, the yield to maturity of these bond funds is close to 4%. This compares to a similar yield for Canadian High Interest Savings Accounts.

Currently, the yield curve is inverted. This means current rates are higher than long term rates. But “normally”, when the yield curve is upwardly sloped, longer term rates will be higher than shorter term rates. This means that investors will normally obtain higher interest rates by investing in bond funds compared to money market funds.

In the current rate environment, investors may be tempted to shorten duration by investing in money market instead of bond funds. But, in the longterm, bond funds have outperformed money market funds because yield curves are more frequently upwardly sloped.

Comparing Canadian Money Market Funds

Low risk Canadian investors can choose from a variety of money market funds and savings accounts.

Click here for a post comparing of Canadian T-Bill funds.

Click here for a list of Canadian High Interest Savings Accounts (“HISAs”) with current rates.

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