Question re: brokered CD at maturity

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swimfin
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Question re: brokered CD at maturity

Post by swimfin »

VG explains that brokered CD's have a fluctuating market value and value can decline due to rising interest rates.

So if I hold a brokered CD until maturity, do I get 100% of my purchase price ? Or is it possible to get less ?
123
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Re: Question re: brokered CD at maturity

Post by 123 »

A brokered CD will pay off in full at maturity. If it does not pay off due to bank failure it may take a couple of days for the FDIC to make good on the CD (assuming your deposits at the bank were within FDIC limits).
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FrankLUSMC
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Re: Question re: brokered CD at maturity

Post by FrankLUSMC »

I have a running 2 year CD ladder using brokered CDs and everyone of them are paid in full at maturity. Haven't had any failures yet.
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Artsdoctor
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Re: Question re: brokered CD at maturity

Post by Artsdoctor »

swimfin wrote: Wed Nov 14, 2018 12:06 pm VG explains that brokered CD's have a fluctuating market value and value can decline due to rising interest rates.

So if I hold a brokered CD until maturity, do I get 100% of my purchase price ? Or is it possible to get less ?
Just to clarify, you're talking about buying a brokered CD when it's initially offered and NOT on the secondary market, right? (If you're buying your brokered CD on the secondary market at a premium, you will only get the face value of the CD at maturity, not your purchase price.)
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AtomicCash
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Re: Question re: brokered CD at maturity

Post by AtomicCash »

swimfin wrote: Wed Nov 14, 2018 12:06 pm VG explains that brokered CD's have a fluctuating market value and value can decline due to rising interest rates.

So if I hold a brokered CD until maturity, do I get 100% of my purchase price ? Or is it possible to get less ?
When you buy a CD directly from a bank, there is usually a well defined early withdraw penalty. So if you bought a 2 year CD from a bank and had an urgent need for the money after only 1 year, you can generally pay the penalty and get your money back.

A brokered CD doesn't have this kind of mechanism for early withdraw. Instead, you have to find someone willing to buy that CD from you. If there is someone willing to buy the CD from you, it will be listed as a "BID" price on the brokerage website. But there might be nobody willing to buy the CD from you and you will have no choice but to hold it until maturity.

The "market value" listed in your brokerage account is the result of an algorithm that tries to determine what the CD would sell for on that day. If you hold the CD until maturity, you will get the full principle plus interest.

Bank default is separate issue that others have covered in the posts above and the amount covered by the FDIC is limited to the face value.

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Alan S.
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Re: Question re: brokered CD at maturity

Post by Alan S. »

Face value + accrued interest up to the insured limit max.
alex_686
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Re: Question re: brokered CD at maturity

Post by alex_686 »

I will point that that bank CDs also fluctuate in value. The critical difference is that bank statements don’t show the mark-to-market value, just the book value.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
keepingitsimple
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Re: Question re: brokered CD at maturity

Post by keepingitsimple »

swimfin wrote: Wed Nov 14, 2018 12:06 pm VG explains that brokered CD's have a fluctuating market value and value can decline due to rising interest rates.

So if I hold a brokered CD until maturity, do I get 100% of my purchase price ? Or is it possible to get less ?
Yes, if you hold a brokered CD until maturity you will get 100% of your purchase price (presuming the CD was a “new issue” CD). Additionally, you will receive interest payments from your CD depending on the length and terms of your CD (monthly, semi-annually, annually or at-maturity interest payments).

I have brokered CD’s (new issues) in my brokerage account. When I look at the market value listed for each CD, on any given day, their values may be listed as greater than or less than my purchase price. Regardless of their listed market values, when they mature the purchase price is what I receive back.
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Kevin M
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Re: Question re: brokered CD at maturity

Post by Kevin M »

alex_686 wrote: Wed Nov 14, 2018 7:18 pm I will point that that bank CDs also fluctuate in value. The critical difference is that bank statements don’t show the mark-to-market value, just the book value.
If by bank CDs you mean direct CDs (brokered CDs also are issued by banks), then there is no market (i.e., you can't sell a direct CD on some open market), so there is no mark to market value. A direct CD always has two known (or knowable) values: the value if you continue to hold and the value if you do an early withdrawal.

You can calculate some theoretical value using discounted cash flows and some discount rate that you feel is appropriate, but it's irrelevant when it comes to liquidation value. A brokered CD has a variable liquidation value that is not known in advance (due to interest rate changes and unknown bid/ask spread), while the liquidation value of a direct CD can always be calculated for any date until maturity.

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alex_686
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Re: Question re: brokered CD at maturity

Post by alex_686 »

Kevin M wrote: Wed Nov 14, 2018 7:54 pm If by bank CDs you mean direct CDs (brokered CDs also are issued by banks), then there is no market (i.e., you can't sell a direct CD on some open market), so there is no mark to market value. A direct CD always has two known (or knowable) values: the value if you continue to hold and the value if you do an early withdrawal.

You can calculate some theoretical value using discounted cash flows and some discount rate that you feel is appropriate, but it's irrelevant when it comes to liquidation value. A brokered CD has a variable liquidation value that is not known in advance (due to interest rate changes and unknown bid/ask spread), while the liquidation value of a direct CD can always be calculated for any date until maturity.

Kevin
Yes, I meant direct CDs.

As for pricing CDs, it is a bit more sophisticated than you suggest. You use a yield curve, so less theoretical and less based on feelings. It would be called "level 2" pricing - you may have seen the term thrown around in the mutual fund docs you read. "Level 1" is when you have actually high quality price quotes.

I bring this up because this is the way a good chunk of brokerage CDs and bonds are priced. Same framework. While liquidity is important, it is of secondary important to the actual economic value of a thing. The point I am trying to make is that both broker and direct CDs bounce around in economic value the same way.

I will concede that many direct CDs have a put option (early redemption) that broker CDs don't have. But that is just a refinement to how we price things, it does not change the underlying fundamentals.
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Kevin M
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Re: Question re: brokered CD at maturity

Post by Kevin M »

alex_686 wrote: Thu Nov 15, 2018 9:43 am
Kevin M wrote: Wed Nov 14, 2018 7:54 pm If by bank CDs you mean direct CDs (brokered CDs also are issued by banks), then there is no market (i.e., you can't sell a direct CD on some open market), so there is no mark to market value. A direct CD always has two known (or knowable) values: the value if you continue to hold and the value if you do an early withdrawal.

You can calculate some theoretical value using discounted cash flows and some discount rate that you feel is appropriate, but it's irrelevant when it comes to liquidation value. A brokered CD has a variable liquidation value that is not known in advance (due to interest rate changes and unknown bid/ask spread), while the liquidation value of a direct CD can always be calculated for any date until maturity.

Kevin
Yes, I meant direct CDs.

As for pricing CDs, it is a bit more sophisticated than you suggest. You use a yield curve, so less theoretical and less based on feelings. It would be called "level 2" pricing - you may have seen the term thrown around in the mutual fund docs you read. "Level 1" is when you have actually high quality price quotes.

I bring this up because this is the way a good chunk of brokerage CDs and bonds are priced. Same framework. While liquidity is important, it is of secondary important to the actual economic value of a thing. The point I am trying to make is that both broker and direct CDs bounce around in economic value the same way.

I will concede that many direct CDs have a put option (early redemption) that broker CDs don't have. But that is just a refinement to how we price things, it does not change the underlying fundamentals.
I understand what you're getting at, and that's exactly what I said--that you can calculate a theoretical present value based on a discounted cashflow model. The problem with selecting a discount rate is that there is no single yield curve that makes sense to use for direct CDs, as the dispersion of direct CD yields is too large. The average yield on a given maturity is ridiculously low compared to the best CD deals, and the latter are all I've ever considered in buying direct CDs, so you can't use average national yields you might find, for example, using FRED. If I were to do that, then every CD I've ever bought would immediately be worth much more than I paid for it.

Even the pricing of brokered CDs is pretty uncertain, as the dispersion of brokered CD yields also is huge, and the dispersion of the bid/ask spreads also is very large. So I pretty much ignore whatever value my brokerage shows for my CDs, knowing that it is unlikely to be very representative of what I'd get if I actually sold. But this is a tangent.

You're twisting what I said about liquidation value. It has nothing to do with liquidity itself--it has to do with how much you would get if you actually did an early withdrawal from your direct CD, which is completely analogous to how much you'd get if you sold your brokered CD. To say that liquidation value is of secondary importance to economic value (whatever you mean by that) is completely wrong from my perspective, as an owner of both direct and brokered CDs. To say that it's just a refinement of pricing also is completely wrong. It's absolutely fundamental to how you should think about direct CDs compared to brokered CDs.

With a direct CD (assumed to have an early withdrawal option--I wouldn't buy one without it), there is a fixed downside and no upside in terms of liquidation value term risk. This can be a big benefit if rates increase a lot, as you can increase your return for the original holding period by doing an early withdrawal and reinvesting at a higher rate, which you cannot do with a brokered CD (or any other marketable bond). This is not just some theoretical thing--it's very real, I've taken advantage of it, I've helped friends and family do it, and many other forum members have done it.

Conversely, the lack of any liquidation value upside with a direct CD prevents one from capitalizing on any theoretical increase in value if yields decrease by much. This makes a direct CD an unlikely candidate for rebalancing into stocks during a flight to safety episode, for example. I can appreciate that my CD has a theoretically higher present value based on discounted cash flows, but there's simply no way I can capitalize that value by liquidating the CD.

I'm not saying that a discounted cash flow (DCF) valuation has no relevance, so I'm not disagreeing with you about that--I'm just saying that it is of limited use, since it has no relevance to liquidation value (again, nothing to do with "liquidity", everything to do with the actual, useful cash value to me). It is useful to point out the DCF/present-value concept, as it's even more erroneous to think that a direct CD has no term risk, but it's also erroneous to ignore the liquidation value in evaluating the term risk.

Thinking about doing early withdrawals when rates have increased, it might be more accurate to say that there are three values for a direct CD: the statement value, the DCF value, and the early withdrawal value.

If I have a CD with a yield of 2% when I could buy a CD (or Treasury) with the same maturity at 3% (in the case of a Treasury in a taxable account, I'd look at taxable-equivalent yield considering the state tax exemption), the early withdrawal value could be quite a bit higher than the DCF value, but it will be lower than the statement value. In this situation, the DCF value has no relevance to me, and I'll probably do an early withdrawal, using the proceeds of the early withdrawal value to reinvest at the higher yield.

In this scenario, I would never bother calculating the DCF value. Not only would it be difficult due to the issue of selecting an appropriate discount rate, it would be completely unnecessary. I would simply calculate the returns I'd get by continuing to hold the CD compared to doing an early withdrawal an investing the proceeds at the higher rate.

Conversely, if I had a 2% direct CD where competitive yield for the same maturity was 1%, I could calculate a DCF value to make myself feel good, but again, it would have absolutely no relevance to decision making. Not only could I not get the DCF value by redeeming the CD, I'd actually get less than the statement value, due to the EWP. I don't need to calculate a DCF to know that I'll continue to hold the CD.

So yes, there is a theoretical DCF value of a direct CD that "bounces around" similar to that of a brokered CD, although selecting the appropriate discount rate is problematical. But with a brokered CD, there is some linkage between the DCF value and the liquidation value, while with a direct CD there is no relationship at all. That's a huge difference, and one that I always consider in deciding between brokered and direct CDs.

Kevin
If I make a calculation error, #Cruncher probably will let me know.
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