Invest in CDs rather than bonds

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Slothmeister
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Invest in CDs rather than bonds

Post by Slothmeister » Tue Sep 19, 2017 5:13 am

So I was thinking of investing in an Intermediate Treasury Bond Index Fund because of it's non-correlation and to counter the Total Stock Market Index Fund in times of market loss. It's about a 1.5% forecast return in 5-years. A 5-year CD can be had at 2.4%. If rates rise, I can get out of the bank CD with little loss (maximum a years interest) with no fear in loss of principal and reinvest in higher rates CD. Plus, NO fees. Is it a no-brainer or am I missing something?

Call_Me_Op
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Re: Invest in CDs rather than bonds

Post by Call_Me_Op » Tue Sep 19, 2017 5:58 am

Slothmeister wrote:
Tue Sep 19, 2017 5:13 am
So I was thinking of investing in an Intermediate Treasury Bond Index Fund because of it's non-correlation and to counter the Total Stock Market Index Fund in times of market loss. It's about a 1.5% forecast return in 5-years. A 5-year CD can be had at 2.4%. If rates rise, I can get out of the bank CD with little loss (maximum a years interest) with no fear in loss of principal and reinvest in higher rates CD. Plus, NO fees. Is it a no-brainer or am I missing something?
It depends upon what you want from your fixed income allocation. The one advantage of the treasury fund is liquidity in a flight to safety. For example, if stocks tank and there is a flight to safety, the value of the treasury fund will increase and you can sell some of it to buy stocks on sale.
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nisiprius
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Re: Invest in CDs rather than bonds

Post by nisiprius » Tue Sep 19, 2017 6:08 am

Slothmeister wrote:
Tue Sep 19, 2017 5:13 am
So I was thinking of investing in an Intermediate Treasury Bond Index Fund because of it's non-correlation and to counter the Total Stock Market Index Fund in times of market loss. It's about a 1.5% forecast return in 5-years. A 5-year CD can be had at 2.4%. If rates rise, I can get out of the bank CD with little loss (maximum a years interest) with no fear in loss of principal and reinvest in higher rates CD. Plus, NO fees. Is it a no-brainer or am I missing something?
You're not missing much, but it isn't a no-brainer, either. It's a brainer. I hope KevinM will notice this thread and weigh in.

The big thing you're missing is hard to assess. You believe that "If rates rise, I can get out of the bank CD with little loss (maximum a years interest)." That is, you believe a CD is a kind of demand deposit and that you have the right to accept the penalty and make an early withdrawal. You probably don't. The terms and conditions on a CD vary; I don't know if there are any limits, but in details they whatever the bank chooses to make them. Buried in the fine print, some CDs have language that says that early withdrawal is "at the bank's discretion" or "with the bank's permission." Some do not.

But even if they don't, most of them have provisions that say the terms and conditions can be changed, with notice--e.g. you might be given 30 days to get out if you don't accept the changes. And some banks in fact have been adding such language to CDs that didn't have it.

For example, read the story by Allan Roth, Ally Bank changes words, not policy, on CDs. Ally added language saying "If we consent to the redemption of a CD or IRA CD prior to the maturity date, we will close the CD and impose a penalty." They also verbally assured Roth that their policy was that they would always allow it. But that's just their policy, not your right.

It's my belief that banks want customers to feel that they can get their money out at any time, subject to penalty, and they really don't want people to think about the possibility that they can't. It's my belief that for public relations reasons, banks will continue to routinely allow early withdrawals, particularly on smaller accounts. But this is because interest rates are not rising sharply, and the number of people trying to make early withdrawals in order to get a higher rate is not enough to be a problem for them.

It is also my belief that if there is an honest-to-gosh big-deal sharp large interest rate rise, enough to spur millions of CD holders to try to cash out their low-interest CDs early, that they can and will start to play hardball on this. Another factor: a bank in good financial shape can easily find the cash to meet early withdrawals. A bank that is in shaky shape may have a desperate need to hold on to every deposit it can, and not to allow withdrawals it can prevent.

Now, this is all just free-floating paranoia and conspiratorial thinking on my part, although there has been at least one case reported where a bank refused an early withdrawal.

The main point is: daily liquidity on a mutual fund is your right. Early withdrawals on a CD may not be. They may be a courtesy that banks routinely extend in good times, but could stop doing if everyone wanted to do it at the same time.

Here are some other things you might be missing. Very simply, the naïve view is that a bond fund is somewhat riskier than a bank account and ought to be expected to have higher return. A quick check will tell you that the total return for Vanguard Total Bond Index Fund over the last five years has been 2.04%. According to BankRate's Historical rates chart, in 2012 five-year CD's were earning 1.1%.

Image

I've had discussions about things with KevinM, who is a very knowledgeable advocate of CDs, and this is all in the area where sensible people can and do come to different conclusions, but my belief is the naïve one: bond funds have more risk and more return, and you will have to give up return in CDs in exchange for the lower risk. On the other hand, the 30-day SEC yield for Total bond is 2.21%, and it is often felt that the SEC yield is the best predictor of future returns, and you can certainly get 5-year 2% CDs, so... maybe not.

One thing that I think you're missing--because there are frequent statement that I think are somewhat misleading--that points in favor of the CDs is that if you are talking about a normal, conservative, intermediate-term bond fund like Total Bond, the "near-zero correlation" thing is not worth much because it is combined with low volatility. To take an extreme case, bank accounts also havezero correlation with stocks but it isn't worth a thing because they have zero volatility. The low-correlation thing only becomes really interesting when the diversifying asset has both a significant positive return (which bonds and good bank accounts have) and volatility that's in the same ballpark as stocks. To use the (highly misleading) "zig and zag" language, which is describing negative correlation rather than low correlation, an asset X that zigs when stocks zag doesn't help much if stocks zag a lot and asset X only zigs a little. To make much hay out of low correlation you need to be using long-term bonds, which I think are inappropriate for ordinary retirement savers.

One reason people get confused about this is that the word "bonds" has two very different meanings. In the world of Treasuries, securities of different terms get three different names. Short-term securities are "bills," medium-term are "notes," and only long-term securities are "bonds." In the world of mutual funds, "bonds" includes all fixed-income securities. The result is that statements are sometimes made about "bonds" (meaning the long Treasury bond) that don't apply, or hardly apply at all, to intermediate-term "bond" funds.
Last edited by nisiprius on Tue Sep 19, 2017 6:20 am, edited 1 time in total.
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nisiprius
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Re: Invest in CDs rather than bonds

Post by nisiprius » Tue Sep 19, 2017 6:15 am

P.S. You are right, though. An awful lot of what's written about "investments" is limited to "things you can buy from a brokerage." A false distinction is often made between "savings" at a bank and "investments" in stocks, bonds, and mutual funds. In reality, "savings" is the term for money you've earned but aren't spending, and "investments" is simply the term for wherever you put that money. Bank accounts are, in fact, a kind of investment--just a very safe and low-yielding investment.

Banks, brokerages, and insurance companies are all competing for your money, and none of them is interested in helping you to understand comparisons between their products and those of the others. If you ask Vanguard where to put money short-term, they will tell you about money market mutual funds and short-term bond funds; they are not going to volunteer thoughtful information about how those alternatives compare to bank accounts or United States savings bonds.

Bank CDs are a credible alternative to bond funds. It's my personal belief that bank CDs should be expected to give somewhat lower returns, and also that there is a credible risk of non-liquidity--a risk, which so far has never shown up, that you might be forced to wait until maturity to get your money out.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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nisiprius
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Re: Invest in CDs rather than bonds

Post by nisiprius » Tue Sep 19, 2017 6:22 am

P. P. S. You say "no fees" for the bank CD. Are you sure? I once had a bank try to charge me a $20 fee for cashing in a CD at maturity rather than rolling it over. I charged into the bank waving the thing they'd mailed me and made a fuss about it and they waived the fee in order to get rid of me, but be careful.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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Re: Invest in CDs rather than bonds

Post by indexonlyplease » Tue Sep 19, 2017 7:50 am

nisiprius wrote:
Tue Sep 19, 2017 6:22 am
P. P. S. You say "no fees" for the bank CD. Are you sure? I once had a bank try to charge me a $20 fee for cashing in a CD at maturity rather than rolling it over. I charged into the bank waving the thing they'd mailed me and made a fuss about it and they waived the fee in order to get rid of me, but be careful.
nisiprius

good explanation. KevinM is alot of help in this area. I recently bought my first online cd at Ally bank. The online bank worried me more than the market. Just some money I did not want in the market. But yes I agree it may be difficult to get the money when markets are crashing. So, like for myself I have my AA set that if the market does make a correction, I have no problem moving money from my fixed into the stocks and changing my AA a little more aggressive . But this does not include the cd. Even if you can cash the cd maybe it will take 2 weeks to get to you. And the correction may be over.

Just a thought.

Slothmeister
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Re: Invest in CDs rather than bonds

Post by Slothmeister » Tue Sep 19, 2017 7:59 am

Call_Me_Op wrote:
Tue Sep 19, 2017 5:58 am
It depends upon what you want from your fixed income allocation. The one advantage of the treasury fund is liquidity in a flight to safety. For example, if stocks tank and there is a flight to safety, the value of the treasury fund will increase and you can sell some of it to buy stocks on sale.
The problem is that one has no idea how much a treasury fund will increase during a market slide and in the mean time, I'd be making very little off of it during good times.

Slothmeister
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Re: Invest in CDs rather than bonds

Post by Slothmeister » Tue Sep 19, 2017 8:05 am

nisiprius wrote:
Tue Sep 19, 2017 6:08 am
Slothmeister wrote:
Tue Sep 19, 2017 5:13 am
So I was thinking of investing in an Intermediate Treasury Bond Index Fund because of it's non-correlation and to counter the Total Stock Market Index Fund in times of market loss. It's about a 1.5% forecast return in 5-years. A 5-year CD can be had at 2.4%. If rates rise, I can get out of the bank CD with little loss (maximum a years interest) with no fear in loss of principal and reinvest in higher rates CD. Plus, NO fees. Is it a no-brainer or am I missing something?
You're not missing much, but it isn't a no-brainer, either. It's a brainer. I hope KevinM will notice this thread and weigh in.

The big thing you're missing is hard to assess. You believe that "If rates rise, I can get out of the bank CD with little loss (maximum a years interest)." That is, you believe a CD is a kind of demand deposit and that you have the right to accept the penalty and make an early withdrawal. You probably don't. The terms and conditions on a CD vary; I don't know if there are any limits, but in details they whatever the bank chooses to make them. Buried in the fine print, some CDs have language that says that early withdrawal is "at the bank's discretion" or "with the bank's permission." Some do not.

But even if they don't, most of them have provisions that say the terms and conditions can be changed, with notice--e.g. you might be given 30 days to get out if you don't accept the changes. And some banks in fact have been adding such language to CDs that didn't have it.

For example, read the story by Allan Roth, Ally Bank changes words, not policy, on CDs. Ally added language saying "If we consent to the redemption of a CD or IRA CD prior to the maturity date, we will close the CD and impose a penalty." They also verbally assured Roth that their policy was that they would always allow it. But that's just their policy, not your right.

It's my belief that banks want customers to feel that they can get their money out at any time, subject to penalty, and they really don't want people to think about the possibility that they can't. It's my belief that for public relations reasons, banks will continue to routinely allow early withdrawals, particularly on smaller accounts. But this is because interest rates are not rising sharply, and the number of people trying to make early withdrawals in order to get a higher rate is not enough to be a problem for them.

It is also my belief that if there is an honest-to-gosh big-deal sharp large interest rate rise, enough to spur millions of CD holders to try to cash out their low-interest CDs early, that they can and will start to play hardball on this. Another factor: a bank in good financial shape can easily find the cash to meet early withdrawals. A bank that is in shaky shape may have a desperate need to hold on to every deposit it can, and not to allow withdrawals it can prevent.

Now, this is all just free-floating paranoia and conspiratorial thinking on my part, although there has been at least one case reported where a bank refused an early withdrawal.

The main point is: daily liquidity on a mutual fund is your right. Early withdrawals on a CD may not be. They may be a courtesy that banks routinely extend in good times, but could stop doing if everyone wanted to do it at the same time.

Here are some other things you might be missing. Very simply, the naïve view is that a bond fund is somewhat riskier than a bank account and ought to be expected to have higher return. A quick check will tell you that the total return for Vanguard Total Bond Index Fund over the last five years has been 2.04%. According to BankRate's Historical rates chart, in 2012 five-year CD's were earning 1.1%.

Image

I've had discussions about things with KevinM, who is a very knowledgeable advocate of CDs, and this is all in the area where sensible people can and do come to different conclusions, but my belief is the naïve one: bond funds have more risk and more return, and you will have to give up return in CDs in exchange for the lower risk. On the other hand, the 30-day SEC yield for Total bond is 2.21%, and it is often felt that the SEC yield is the best predictor of future returns, and you can certainly get 5-year 2% CDs, so... maybe not.

One thing that I think you're missing--because there are frequent statement that I think are somewhat misleading--that points in favor of the CDs is that if you are talking about a normal, conservative, intermediate-term bond fund like Total Bond, the "near-zero correlation" thing is not worth much because it is combined with low volatility. To take an extreme case, bank accounts also havezero correlation with stocks but it isn't worth a thing because they have zero volatility. The low-correlation thing only becomes really interesting when the diversifying asset has both a significant positive return (which bonds and good bank accounts have) and volatility that's in the same ballpark as stocks. To use the (highly misleading) "zig and zag" language, which is describing negative correlation rather than low correlation, an asset X that zigs when stocks zag doesn't help much if stocks zag a lot and asset X only zigs a little. To make much hay out of low correlation you need to be using long-term bonds, which I think are inappropriate for ordinary retirement savers.

One reason people get confused about this is that the word "bonds" has two very different meanings. In the world of Treasuries, securities of different terms get three different names. Short-term securities are "bills," medium-term are "notes," and only long-term securities are "bonds." In the world of mutual funds, "bonds" includes all fixed-income securities. The result is that statements are sometimes made about "bonds" (meaning the long Treasury bond) that don't apply, or hardly apply at all, to intermediate-term "bond" funds.
Thanks for your extensive reply! I think you make a good point to check the fine print and the possibility of some banks defaulting during a swarm of investors opting out. One wouldn't want to get excited about going for higher rates only to find there are additional fees or restrictions upon jumping ship.

Slothmeister
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Re: Invest in CDs rather than bonds

Post by Slothmeister » Tue Sep 19, 2017 8:14 am

indexonlyplease wrote:
Tue Sep 19, 2017 7:50 am

nisiprius

good explanation. KevinM is alot of help in this area. I recently bought my first online cd at Ally bank. The online bank worried me more than the market. Just some money I did not want in the market. But yes I agree it may be difficult to get the money when markets are crashing. So, like for myself I have my AA set that if the market does make a correction, I have no problem moving money from my fixed into the stocks and changing my AA a little more aggressive . But this does not include the cd. Even if you can cash the cd maybe it will take 2 weeks to get to you. And the correction may be over.

Just a thought.
A CD takes 2 weeks to process? Thanks for the info! Maybe it would be wise to to put some in an ultra liquid high-yield savings that can help when new opportunities come about.

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Re: Invest in CDs rather than bonds

Post by welderwannabe » Tue Sep 19, 2017 9:02 am

I split the difference in my portfolio. For my non-corporate bond allocation in tax advantaged I hold 50% in CDs and 50% in Treasuries.
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

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