Using CD's instead of bonds

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fsrph
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Using CD's instead of bonds

Post by fsrph » Sat Feb 13, 2016 4:35 pm

Anyone going heavily into CD's replacing bonds in their fixed income allocation? I currently have approx 70% of fixed income in CD's. It's a lot of money. Here's why. Bond yields are so low, what's the 10 year treasury at 1.75%? Why wouldn't I take over 100 basis points? I have been selective in the CD's I chose (From Penfed, Northwest, Valor and NASA). The blended rate of all the CD's is 2.88%. Anyone doing something similar? Or and I missing some downside risk using CD's so heavily?

Francis
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Phineas J. Whoopee
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Re: Using CD's instead of bonds

Post by Phineas J. Whoopee » Sat Feb 13, 2016 4:38 pm

Plenty of people are doing it, and for we small investors, for whom $250,000 in deposit insurance is meaningful, it's a good deal these days so long as the CDs are carefully chosen.

In case anybody else who happens across this thread would like the link, here's a good place to look up CD offers, ranked by rate.

PJW

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Re: Using CD's instead of bonds

Post by Call_Me_Op » Sat Feb 13, 2016 5:01 pm

What PJW has told you is correct. CD's, especially purchased directly from a bank, can be a good deal right now. I am more comfortable with CD's than bond funds, but you need to study them to convince yourself. The fact that you asked this questions suggests that you are uneasy/uncertain about your decision to invest in CD's.
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patrick013
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Re: Using CD's instead of bonds

Post by patrick013 » Sat Feb 13, 2016 6:59 pm

One of the first portfolios I ever heard of was the S&P 500 and
CD's. I would like to buy a 5 year CD every year.
age in bonds, buy-and-hold, 10 year business cycle

dbr
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Re: Using CD's instead of bonds

Post by dbr » Sat Feb 13, 2016 7:08 pm

Many postings here on this forum have mentioned, suggested, or outright recommended the use of CDs for fixed income. There are many discussions of details including ladders, bank CDs, brokered CD's, finding the best deals on CDs, issues about early redemption of CDs, etc. Some browsing would find many of these conversations.

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fsrph
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Re: Using CD's instead of bonds

Post by fsrph » Sat Feb 13, 2016 7:17 pm

Call_Me_Op wrote:What PJW has told you is correct. CD's, especially purchased directly from a bank, can be a good deal right now. I am more comfortable with CD's than bond funds, but you need to study them to convince yourself. The fact that you asked this questions suggests that you are uneasy/uncertain about your decision to invest in CD's.
Not uneasy at all. Just wondering if others are using CD's more and if not, why not. I see CD's, if you wait for good deals, being superior to bond funds. Guaranteed return of principle, decent interest and govt insurance. What's not to like?

Francis
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Leif
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Re: Using CD's instead of bonds

Post by Leif » Sat Feb 13, 2016 7:31 pm

I'm building a 5 year CD ladder, currently using Synchrony 5 year CDs (2.25%). I plan to use that as a supplement to my income from retirement to 70 and to help fund taxes on Roth conversions during the same time period.

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Re: Using CD's instead of bonds

Post by Rysto » Sat Feb 13, 2016 9:49 pm

Half of my FI allocation is in a non-redeemable CD ladder. As you say, it's hard to pass up the combination of better yield with no increase in default risk. The one issue is liquidity, but I only expect that to ever come up when I need to rebalance. That's why the other half of my FI is in a bond fund.

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Re: Using CD's instead of bonds

Post by gvsucavie03 » Sat Feb 13, 2016 10:14 pm

Isn't yield only one piece of the bond picture, though? I admit I don't know nearly as much about bonds as some on this forum.... Does "total return" come into play to compare apples to apples with a CD ladder?

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Re: Using CD's instead of bonds

Post by Kevin M » Sat Feb 13, 2016 11:03 pm

fsrph wrote:Anyone doing something similar??
Yes. I've been posting here and on my blog about the benefits of CDs, especially direct CDs, for about five years. Try this Google search: cd "kevin m" site:bogleheads.org (1,270 results).

My first blog post about CDs in October 2010: Ally Bank 5 Year CD

A more recent BH post of mine, referencing a 3-part blog post series I did on the 5-year results of CDs vs. other fixed-income alternatives: CD 5-Year Report Card - Bogleheads.org.

I too have 70%-75% of fixed income in (direct) CDs for the reasons that you already understand.

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Re: Using CD's instead of bonds

Post by Kevin M » Sat Feb 13, 2016 11:10 pm

gvsucavie03 wrote:Isn't yield only one piece of the bond picture, though? I admit I don't know nearly as much about bonds as some on this forum.... Does "total return" come into play to compare apples to apples with a CD ladder?
Yes, total return is what matters. Sometimes the risk of a bond fund will pay off, and you will earn more than the yield (SEC yield), and sometimes it will "show up", and you will earn less (and even lose money, as in 2013). I've posted analysis showing that for Total Bond fund, for example, 5-year and 10-year annualized total returns have often been +/-0.5% of initial SEC yield, and sometimes +/-1% or even more.

In recent years, total returns (annualized) have tended to be higher than initial SEC yield, due to falling yields and a positively-sloped yield curve. Yields can't fall forever, and can't fall (much) below 0%, so bond returns over the next 10-30 years cannot resemble the last 10-30 years.

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patriciamgr2
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Re: Using CD's instead of bonds

Post by patriciamgr2 » Sat Feb 13, 2016 11:14 pm

Kevin M. a question. do CDs compound interest? Is there a particular interest calculation (APY?) that is the right one to use to compare CDs with bond fund yields? Thanks for sharing your expertise with the group. Regards

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Re: Using CD's instead of bonds

Post by dunscap » Sat Feb 13, 2016 11:45 pm

patriciamgr2 wrote:Kevin M. a question. do CDs compound interest?
With direct-sold CDs there's generally an option to either pay out the interest or retain it in the CD. In the latter case interest would compound.

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Re: Using CD's instead of bonds

Post by longinvest » Sun Feb 14, 2016 8:15 am

People used to separate assets that pay investors to hold them into three classes:
  • Stocks
  • Bonds
  • Cash
Let me see. The U.S. Securities and Exchange Commission (SEC) still does that:

http://www.sec.gov/investor/pubs/assetallocation.htm
(I have underlined the three classes in the citation)
[...]
Investment Choices
While the SEC cannot recommend any particular investment product, you should know that a vast array of investment products exists - including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy.[...]
Here's how the SEC describes cash in this same document:

(I have underlined the mention of CDs)
Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories. The chances of losing money on an investment in this asset category are generally extremely low. The federal government guarantees many investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do occur, but infrequently. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.
There is nothing wrong with using cash and cash equivalents in a portfolio.

Older texts used to propose asset allocation models that included all three asset classes. In modern days, the tendency is to recommend holding one's emergency fund in cash or cash equivalents (thereby excluding the emergency fund from the portfolio), and to allocate the portfolio between stocks and bonds.

One could use the older approach and integrate the emergency fund back into the portfolio, and then simply allocate the portfolio between the three assets classes.

As a Boglehead, I would recommend including all three asset classes as part of an investor's holdings.

Personally, I keep a reasonable amount of money in cash and cash equivalents to meet upcoming expenses and possible emergencies. I divide the rest between stocks and bonds. But, other asset allocation models diversified across the three asset classes are fine.
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Re: Using CD's instead of bonds

Post by gvsucavie03 » Sun Feb 14, 2016 8:27 am

longinvest wrote:People used to separate assets that pay investors to hold them into three classes:
  • Stocks
  • Bonds
  • Cash
Let me see. The U.S. Securities and Exchange Commission (SEC) still does that:

http://www.sec.gov/investor/pubs/assetallocation.htm
(I have underlined the three classes in the citation)
[...]
Investment Choices
While the SEC cannot recommend any particular investment product, you should know that a vast array of investment products exists - including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy.[...]
Here's how the SEC describes cash in this same document:

(I have underlined the mention of CDs)
Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories. The chances of losing money on an investment in this asset category are generally extremely low. The federal government guarantees many investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do occur, but infrequently. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.
There is nothing wrong with using cash and cash equivalents in a portfolio.

Older texts used to propose asset allocation models that included all three asset classes. In modern days, the tendency is to recommend holding one's emergency fund in cash or cash equivalents (thereby excluding the emergency fund from the portfolio), and to allocate the portfolio between stocks and bonds.

One could use the older approach and integrate the emergency fund back into the portfolio, and then simply allocate the portfolio between the three assets classes.

As a Boglehead, I would recommend including all three asset classes as part of an investor's holdings.

Personally, I keep a reasonable amount of money in cash and cash equivalents to meet upcoming expenses and possible emergencies. I divide the rest between stocks and bonds. But, other asset allocation models diversified across the three asset classes are fine.
Great point, great reminder. MMAs, CDs, liquid cash.. Perhaps all should be used. A great idea would be to have enough to use that as income at the start of retirement and start converting pre-tax investments into Roth IRAs at lower tax brackets.

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Re: Using CD's instead of bonds

Post by Valuethinker » Sun Feb 14, 2016 9:48 am

fsrph wrote:Anyone going heavily into CD's replacing bonds in their fixed income allocation? I currently have approx 70% of fixed income in CD's. It's a lot of money. Here's why. Bond yields are so low, what's the 10 year treasury at 1.75%? Why wouldn't I take over 100 basis points? I have been selective in the CD's I chose (From Penfed, Northwest, Valor and NASA). The blended rate of all the CD's is 2.88%. Anyone doing something similar? Or and I missing some downside risk using CD's so heavily?

Francis
In light of what is happening in global financial markets:

- CDs are definitely preferred to bonds (as long as within FDIC limits for that institution)

- I would extend the duration of my CD portfolio. More 5 year CDs, maybe even 7 year ones*. The reason being it's no longer impossible (although still unlikely) that the US goes to negative interest rates.

Roughly 30% of all developed world government debt is now at a negative nominal yield (in effect the discounted sum of the coupons plus the redemption is less than the current price). (A figure I was quoted but have not crosschecked).

If US interest rates rise the mechanisms for CDs mean that although you will experience virtual capital losses, in reality you will redeem at par-- your main loss will be the opportunity cost to have grabbed higher rates. This is why you build a ladder. If inflation were to shoot up dramatically it would hurt, but you might be able to cash the CDs in, and in any case your duration of portfolio would still be c. 5 years or less.

But negative interest rates on US bank accounts are still unlikely, but no longer impossible. Ditto US government debt (are some maturities negative yields? Have not checked).

* 10 year ones. I wouldn't go "out there" for a big chunk of your money, but 10-20% of a portfolio in 10 year CDs with an average maturity of CD of 5 years is, well, possible. An alternative is to invest in some really long maturity US Treasuries ie 20-30 years, as a "barbel" to your portfolio against deflation.
Last edited by Valuethinker on Sun Feb 14, 2016 10:08 am, edited 1 time in total.

hudson
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Re: Using CD's instead of bonds

Post by hudson » Sun Feb 14, 2016 10:04 am

It may be worth looking at CDs and Municipal Bond Funds

If you put CDs in a taxable account, you have to pay taxes.

You can get a 5 year CD at 2.25%...but municipal bond funds might be worth a look.

Baird BMBIX...Intermediate Term Municipal Bond Fund distributed 2.4% last year.
....no federal tax
....it holds 97% AAA/AA bonds
....50% of the holdings are prefunded
....that's not quite as safe as treasuries or CDs....but almost

I like CDs AND Muni Funds.

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Re: Using CD's instead of bonds

Post by patrick013 » Sun Feb 14, 2016 1:21 pm

hudson wrote:I like CDs AND Muni Funds.
I have good luck finding muni's that yield 2% and trade at
a discount. Have to go out about 10 years for AAA/AA.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Using CD's instead of bonds

Post by Kevin M » Sun Feb 14, 2016 5:27 pm

longinvest wrote: (I have underlined the mention of CDs)
Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories.
There is nothing wrong with using cash and cash equivalents in a portfolio.
To equate a 5-year CD to cash is just silly not rational.

CDs in the context of the SEC quote are almost certainly limited to a maximum maturity of one year, since 1-year maturity is the conventional dividing line between cash and bonds (or in more academic terms, between money markets and capital markets). Since Treasury bills (by definition maturity of one year or less) generally are considered cash, it would be consistent to classify CDs with maturities of one year or less as cash, although a Treasury bill more liquid than a CD. CDs with maturities of one year or less often are referenced as a common holding of money market funds, which I'm sure everyone agrees fits into the cash asset category.

It's a mistake to base one's investment policy on SEC quotes and antiquated notions (e.g., CDs are for retired grandmothers) without actually looking at the risk and return characteristics of the investments.

A simple example is all that's required to refute the notion that CDs have lower returns than bonds, and thus show that the SEC statement about "the lowest return of the three major asset categories" does not apply to a CD of the same (longer) maturity as a Treasury bond (or note). Here it is--look at this very carefully:
  • 1.20% - yield to maturity of a 5-year Treasury bond*.
  • 2.25% - APY of a 5-year CD easily obtained from several banks or credit unions.
  • 2.50% - APY of a 5-year CD that is available to me at a credit union.
* Source: Daily Treasury Yield Curve Rates. Technically a 5-year Treasury is a note, but in terms of common asset class categorization, it's a bond.

So unless you want to argue that a 5-year Treasury is not a bond, please explain to us how the 5-year CD, which you seem to insist on classifying as cash, has a guaranteed 5-year annualized return that is 105 or 130 basis points higher than the 5-year Treasury?

Here's another one:
  • 1.50% - yield to maturity of a 7-year Treasury as of 2/12/2016
  • 3.00% - APY of a 7-year CD I am buying in an IRA at a credit union that anyone can join.
So the CD has a guaranteed annualized return that is 150 basis points higher than the Treasury of same maturity.

So the "lowest return" notion has been categorically debunked.

Now let's talk about risk, i.e., "the safest investments" statement in the SEC quote. This makes it crystal clear that the statement is referring to short-term CDs. A 5-year brokered CD has just as much risk as a 5-year Treasury. Both are backed by the US government, so have essentially no credit risk. But both have the same term risk (interest-rate risk). It can be argued that the 5-year brokered CD actually is riskier due to much less liquidity for CDs than for Treasuries, so if you sell before maturity, you will suffer a larger discount than if you sold the 5-year Treasury before maturity.

So the risk part of the statement is debunked as long as we're talking about brokered CDs with terms longer than one year.

Now on to the magic of good CDs purchased directly from banks or credit unions (direct CDs) with good early withdrawal terms. This is where the direct CD shines, since term risk is limited to the early withdrawal penalty (EWP). The 5-year 2.25% CD will lose about 1.13% (no more, no less) if an early withdrawal is done to reinvest at a higher rate, no matter how much rates increase. By contrast, the 5-year CD could lose 5% or more if rates increased rapidly by 1% (one percentage point) or more.

So here we have a fixed-income investment with a guaranteed annualized return that is significantly higher than a "bond" with the same credit risk, but that has much less term risk. Higher return, lower risk--as the OP asked, what's not to like?

One caveat is that CD disclosures often give the bank or credit union the right to refuse an early withdrawal or to change terms on existing CDs. Although we have heard of only two documented instances of this happening (see DepositAccounts.com for details), and there were no new reports of it happening when 5-year Treasury yields rose by more than 100 basis points in 2013, it still is a valid concern. So worst case, we earn 100-150 basis points more yield with the same risk as a 5-year or 7-year Treasury, and should consider maintaining enough liquidity that this caveat is not a big concern for us (which is what I do).

Now there are good reasons for some investors to stick with bond funds over CDs, even though good CDs have a demonstrably superior risk/return profile. An obvious one is that all of your portfolio is in a 401k or 403b, and you don't have a choice. Another one is that you prefer simplicity to optimizing risk/return. There probably are other good reasons, but calling CDs cash is not one of them.

Another reason often proffered to stick with bonds is the possibility of negative correlation with stocks during times of financial stress, as we have seen to some extent recently, and as we saw big time in late 2008. The flaw here is all-or-none thinking. Assuming the flexibility do do so (e.g., all portfolio not in a 401k/403b), one can hold enough of their fixed income in Treasuries to benefit from this, if it happens, but hold the bulk of their fixed income in higher-yielding, lower risk direct CDs.

The flight-to-safety characteristic of Treasuries is only of benefit to the extent one rebalances into stocks when it happens, unless you believe that stocks will remain depressed and Treasury rates will remain low for the rest of your investment horizon. You probably won't need more than a portion of your fixed income for such rebalancing, so why accept lower yields with more risk for the rest of it?

Further, long-term Treasuries have provided much more of this flight-to-safety benefit in recent years. For example, Vanguard long-term Treasury is up 8.7% YTD, while intermediate-term Treasury is up only 3.21%, and short-term is up only 1.03%. So why not hold a smaller portion of long-term Treasuries, keeping even more of the bulk of your fixed income in superior risk/return CDs?

Some say "I don't want to own long-term bonds", but seem to ignore the fact that they do own long-term bonds inside of their total bond market fund. So why not replace the lower-yielding, medium-term and short-term Treasuries with much higher-yielding (and potentially lower risk) direct CDs, and own the long-term Treasuries separately for the rebalancing benefit?

Kevin
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longinvest
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Re: Using CD's instead of bonds

Post by longinvest » Sun Feb 14, 2016 5:33 pm

Kevin M wrote:
longinvest wrote: (I have underlined the mention of CDs)
Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories.
There is nothing wrong with using cash and cash equivalents in a portfolio.
To equate a 5-year CD to cash is just silly not rational.
Kevin,

CDs do not have a fluctuating market value. As such, they have a property that is specific to cash, and that even short-term bonds do not have.

Note that it is not because CDs are a cash investment that they can't return more than other investments. It is entirely possible for them to do so.
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Re: Using CD's instead of bonds

Post by stevewolfe » Sun Feb 14, 2016 6:04 pm

longinvest wrote: CDs do not have a fluctuating market value. As such, they have a property that is specific to cash, and that even short-term bonds do not have.
That's only true for direct retail CDs and not brokered CDs.

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Re: Using CD's instead of bonds

Post by SpaceCowboy » Sun Feb 14, 2016 6:05 pm

longinvest wrote:CDs do not have a fluctuating market value. As such, they have a property that is specific to cash, and that even short-term bonds do not have.
Not true. brokered CDs do have a fluctuating market value. Direct purchased CDs do not.
This semantic argument strikes me as silly. Cash, cash equivalents, bonds are all fixed income investments. Pure cash (currency and demand deposits) clearly has the highest liquidity, but once you get outside of that realm it depends on the specifics on the bond or CD as to its particular liquidity issues and return.
I, like Kevin M, believe that direct purchased CDs along with sometimes available high yielding stable value funds are superior fixed income investments to total bond and treasuries in the current market environment. Guess that makes me a market timer.

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Re: Using CD's instead of bonds

Post by Kevin M » Sun Feb 14, 2016 6:18 pm

longinvest wrote: Kevin,

CDs do not have a fluctuating market value. As such, they have a property that is specific to cash, and that even short-term bonds do not have.

Note that it is not because CDs are a cash investment that they can't return more than other investments. It is entirely possible for them to do so.
You should read my reply more carefully. Brokered CDs do indeed have fluctuating market value, so we have to carefully specify if we're discussing brokered CDs or direct CDs.

Some even argue that direct CDs have fluctuating value, if valued based on the present value of future cash flows. I disagree that this is necessarily an effective way to view it, because there are too many issues, such as what to use as the discount rate, and whether using the selected discount rate really makes sense. Also, the liquidation value is what really matters in practical terms.

The SEC statement you quoted referred to both return and risk in characterizing cash, so you can't just cherry pick one part and ignore the other if you're going to use that statement as your argument to prefer bonds over CDs. Repeated posts on this forum make it abundantly clear that people do not understand how to properly compare CDs to bonds, so I think it's important to keep explaining that the notion that CDs have lower expected returns than bonds of comparable maturity is incorrect, even more so when adjusted for risk.

I have never found that going back to the fundamental notions of term risk and credit risk is not a much superior way to view one's fixed income investments rather than simply classifying them as cash or bonds. The latter is overly simplistic, and does not factor in the unusual interest-rate environment we've been living in for some years, nor the huge advantage that retail investors have over institutional investors due to the ability to take advantage of federal deposit insurance (FDIC or NCUA) on deposit accounts.

Having said that, I admit that I do use a cash category for my investments, but it applies only to investments with zero term risk (direct CDs have some small term risk due to the EWP and the possibility of an early withdrawal being disallowed, so they do not count as cash--they are their own sub-category of fixed income). But then I further sub-divide cash into high-yield and low-yield categories, since the approximately 0% I earn in a money market account is not at all comparable to the 3% I earn in a reward checking account, although they both have zero term risk. My goal is to hold an absolute minimum amount in 0% cash, a bit more but not too much in 1% cash, and as much as possible in 3% cash.

Kevin
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Re: Using CD's instead of bonds

Post by whodidntante » Sun Feb 14, 2016 6:21 pm

Some prefer bonds because of the negative correlation to stocks, which means as stock prices fall, there is a tendency for bonds to appreciate. That has occurred in the current downturn, for example. However, that doesn't apply under all market conditions.

As for me, I don't see a reason to buy bonds right now, for a small investor. You're welcome to label this market timing, and maybe it is. But I think being in CDs is fine.

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Phineas J. Whoopee
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Re: Using CD's instead of bonds

Post by Phineas J. Whoopee » Sun Feb 14, 2016 7:26 pm

whodidntante wrote:Some prefer bonds because of the negative correlation to stocks, which means as stock prices fall, there is a tendency for bonds to appreciate. That has occurred in the current downturn, for example. However, that doesn't apply under all market conditions.
...
Except there isn't one. Investment-grade bonds have approximately zero correlation to stocks. For what you wrote to be true, the correlation would have to be negative.

It is true that in financial panics, like the one we experienced several years ago but which hadn't occurred for decades before that, US Treasury bonds benefit from the flight to quality, but that is not by any means a reliable behavior whenever stocks happen to be down.

PJW

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patrick013
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Re: Using CD's instead of bonds

Post by patrick013 » Sun Feb 14, 2016 7:57 pm

When bonds deviate from their average spread the explanation
is frequently explained by bond supply and volume of bond sales.
New issuances or lack thereof, foreign purchases, fed holdings,
temporary spikes or decline in volume other than flight to quality...but the
important thing is to identify the reason and move forward, at least to me.

As soon as one develops a methodology something else happens that
throws it out the window. :)
age in bonds, buy-and-hold, 10 year business cycle

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Re: Using CD's instead of bonds

Post by mjb » Sun Feb 14, 2016 8:03 pm

Two things to consider.

Historically, a CD beats a treasury bond of equal maturity up until about the 5 year range.

With the current historically low yields, there is not much room for bond appreciation. That being said, yields are not significantly lower than pre-1960s levels for reserved currencies. Yields for U.S. Treasuries and GBP Sovereign bonds (when the UK was the "superpower") in near 0 inflation environments were in the 2.5-3.5% range.

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Re: Using CD's instead of bonds

Post by friar1610 » Sun Feb 14, 2016 8:25 pm

FWIW I've always felt most comfortable with a fixed income allocation consisting of:

- some amount of cash in MM accts (about 4-5% of total port)
- a ST Index bond fund ("almost cash" to my way of thinking)
- VG Total Bond Market
- a bunch of I-bonds (many of which are from the good old days of 3.4% fixed interest)
- a 5 year CD ladder.

I also sometimes jump on PenFed or Navy Federal deals when they're offered even though these don't really fit into the ladder.

There might be smarter ways of doing fixed income but this works for me.

Disclosures: 70 yo, good inflation indexed pension + SS, 40/55/5 AA.
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Re: Using CD's instead of bonds

Post by Desert » Sun Feb 14, 2016 9:41 pm

Kevin M wrote:
longinvest wrote: (I have underlined the mention of CDs)
Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories.
There is nothing wrong with using cash and cash equivalents in a portfolio.
To equate a 5-year CD to cash is just silly not rational.

CDs in the context of the SEC quote are almost certainly limited to a maximum maturity of one year, since 1-year maturity is the conventional dividing line between cash and bonds (or in more academic terms, between money markets and capital markets). Since Treasury bills (by definition maturity of one year or less) generally are considered cash, it would be consistent to classify CDs with maturities of one year or less as cash, although a Treasury bill more liquid than a CD. CDs with maturities of one year or less often are referenced as a common holding of money market funds, which I'm sure everyone agrees fits into the cash asset category.

It's a mistake to base one's investment policy on SEC quotes and antiquated notions (e.g., CDs are for retired grandmothers) without actually looking at the risk and return characteristics of the investments.

A simple example is all that's required to refute the notion that CDs have lower returns than bonds, and thus show that the SEC statement about "the lowest return of the three major asset categories" does not apply to a CD of the same (longer) maturity as a Treasury bond (or note). Here it is--look at this very carefully:
  • 1.20% - yield to maturity of a 5-year Treasury bond*.
  • 2.25% - APY of a 5-year CD easily obtained from several banks or credit unions.
  • 2.50% - APY of a 5-year CD that is available to me at a credit union.
* Source: Daily Treasury Yield Curve Rates. Technically a 5-year Treasury is a note, but in terms of common asset class categorization, it's a bond.

So unless you want to argue that a 5-year Treasury is not a bond, please explain to us how the 5-year CD, which you seem to insist on classifying as cash, has a guaranteed 5-year annualized return that is 105 or 130 basis points higher than the 5-year Treasury?

Here's another one:
  • 1.50% - yield to maturity of a 7-year Treasury as of 2/12/2016
  • 3.00% - APY of a 7-year CD I am buying in an IRA at a credit union that anyone can join.
So the CD has a guaranteed annualized return that is 150 basis points higher than the Treasury of same maturity.

So the "lowest return" notion has been categorically debunked.

Now let's talk about risk, i.e., "the safest investments" statement in the SEC quote. This makes it crystal clear that the statement is referring to short-term CDs. A 5-year brokered CD has just as much risk as a 5-year Treasury. Both are backed by the US government, so have essentially no credit risk. But both have the same term risk (interest-rate risk). It can be argued that the 5-year brokered CD actually is riskier due to much less liquidity for CDs than for Treasuries, so if you sell before maturity, you will suffer a larger discount than if you sold the 5-year Treasury before maturity.

So the risk part of the statement is debunked as long as we're talking about brokered CDs with terms longer than one year.

Now on to the magic of good CDs purchased directly from banks or credit unions (direct CDs) with good early withdrawal terms. This is where the direct CD shines, since term risk is limited to the early withdrawal penalty (EWP). The 5-year 2.25% CD will lose about 1.13% (no more, no less) if an early withdrawal is done to reinvest at a higher rate, no matter how much rates increase. By contrast, the 5-year CD could lose 5% or more if rates increased rapidly by 1% (one percentage point) or more.

So here we have a fixed-income investment with a guaranteed annualized return that is significantly higher than a "bond" with the same credit risk, but that has much less term risk. Higher return, lower risk--as the OP asked, what's not to like?

One caveat is that CD disclosures often give the bank or credit union the right to refuse an early withdrawal or to change terms on existing CDs. Although we have heard of only two documented instances of this happening (see DepositAccounts.com for details), and there were no new reports of it happening when 5-year Treasury yields rose by more than 100 basis points in 2013, it still is a valid concern. So worst case, we earn 100-150 basis points more yield with the same risk as a 5-year or 7-year Treasury, and should consider maintaining enough liquidity that this caveat is not a big concern for us (which is what I do).

Now there are good reasons for some investors to stick with bond funds over CDs, even though good CDs have a demonstrably superior risk/return profile. An obvious one is that all of your portfolio is in a 401k or 403b, and you don't have a choice. Another one is that you prefer simplicity to optimizing risk/return. There probably are other good reasons, but calling CDs cash is not one of them.

Another reason often proffered to stick with bonds is the possibility of negative correlation with stocks during times of financial stress, as we have seen to some extent recently, and as we saw big time in late 2008. The flaw here is all-or-none thinking. Assuming the flexibility do do so (e.g., all portfolio not in a 401k/403b), one can hold enough of their fixed income in Treasuries to benefit from this, if it happens, but hold the bulk of their fixed income in higher-yielding, lower risk direct CDs.

The flight-to-safety characteristic of Treasuries is only of benefit to the extent one rebalances into stocks when it happens, unless you believe that stocks will remain depressed and Treasury rates will remain low for the rest of your investment horizon. You probably won't need more than a portion of your fixed income for such rebalancing, so why accept lower yields with more risk for the rest of it?

Further, long-term Treasuries have provided much more of this flight-to-safety benefit in recent years. For example, Vanguard long-term Treasury is up 8.7% YTD, while intermediate-term Treasury is up only 3.21%, and short-term is up only 1.03%. So why not hold a smaller portion of long-term Treasuries, keeping even more of the bulk of your fixed income in superior risk/return CDs?

Some say "I don't want to own long-term bonds", but seem to ignore the fact that they do own long-term bonds inside of their total bond market fund. So why not replace the lower-yielding, medium-term and short-term Treasuries with much higher-yielding (and potentially lower risk) direct CDs, and own the long-term Treasuries separately for the rebalancing benefit?

Kevin
This might be the best post I've ever read regarding CD's. I agree that the (small) free lunch available to individual investors via CD's is worth the additional effort. I've chosen to move all intermediate bond fund allocation to CD's, maintaining a small slice to LTT's for portfolio draw-down reduction in flight-to-safety scenarios. I currently hold 60% fixed, with 48% in CD's/IT and 12% LTT's. This approximates the duration of a 10 year treasury, with higher yield and similar interest rate sensitivity.

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Re: Using CD's instead of bonds

Post by longinvest » Sun Feb 14, 2016 9:44 pm

I agree that brokered CDs are bonds, but bank CDs (usually with early withdrawal provisions) are cash (e.g. they have a non-fluctuating principal value).

As for the SEC's statement on returns, here's what I think.

If the SEC's intent was to compare bond coupons and rates on cash, maybe the SEC has forgotten about pre-1930 years. If the intent was to compare yields, then it is simply mistaken. If the intent was really to compare past returns, then the SEC was totally wrong; past 1-year returns on cash were sometimes higher than that of other asset classes (stocks and bonds).

It is my opinion is that nobody, not even the SEC, can predict* future returns.

* Note that no prediction is needed to know the nominal future value of a CD with compound interest on the day it matures. But, as soon as reinvestment is involved, even on a cash investment, one would have to guess future interest rates to predict a return.
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Re: Using CD's instead of bonds

Post by freebeer » Sun Feb 14, 2016 10:23 pm

Valuethinker wrote:
fsrph wrote:Anyone going heavily into CD's replacing bonds in their fixed income allocation?...
In light of what is happening in global financial markets:

- CDs are definitely preferred to bonds (as long as within FDIC limits for that institution)

- I would extend the duration of my CD portfolio...
A Bogleheads core principle is don't try to time the market: whatever you can forsee, the market has already priced in, and if you are making decisions based on what has recently happened (the Nisiprius-correct verb tense for "what is happening..."), you are highly likely to under-perform.

Yet many of us who wouldn't dream of doing this with our equities (myself included) try to time the market with our fixed income allocation. I don't see why it makes any more sense than for equities. In fact this thread had me warming to the idea that a minor shift into CDs made sense for me until reading the "in light of what is happening..." which I take as a blinking yellow warning light reminding me to "stay the course".

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Re: Using CD's instead of bonds

Post by longinvest » Sun Feb 14, 2016 10:34 pm

freebeer wrote:"stay the course".
+1 :thumbsup

Sometimes people get lucky, other times they don't, even with short-term bonds and CDs:

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Re: Using CD's instead of bonds

Post by weltschmerz » Sun Feb 14, 2016 10:38 pm

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Re: Using CD's instead of bonds

Post by uberme » Sun Feb 14, 2016 10:48 pm

This thread is awesome; I've been building an allocation and never even thought of including a CD ladder in my fixed income portion. Makes much more sense to include this along with something like BND. Thanks!

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Re: Using CD's instead of bonds

Post by Desert » Sun Feb 14, 2016 10:50 pm

The Dan wrote:Where is ogd? He normally would chime in to let folks know about "riding the yield curve":

viewtopic.php?t=132601

Basically, if you buy treasury bonds at the steepest part of the yield curve, then you will accrue capital gains, in addition to your normal interest payments. This does not occur with non-brokered bank CDs.
Right, as long as the yield curve is upward-sloping. It's another risk/reward factor that should be considered.

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Re: Using CD's instead of bonds

Post by gvsucavie03 » Mon Feb 15, 2016 8:48 am

A pre-retirement CD ladder seems to make sense to some degree. Prior to that, bonds are the better long-term investments. A CD ladder early on only seems to make sense for diversifying emergency funds and savings that will not be part of retirement accounts.

A savvy person might consider a 3-4% checking account and keep the savings portion seperate on your spreadsheet. Better yields than CDs and MMAs. Yes, you need to do a minimum number of debit transactions, but if savings is thoughtfully and carefully mixed with the everyday checking, most folks would easily hit the minimum each month. One I'm looking at is 3% with 10 debit transactions per month up to $15,000.

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Re: Using CD's instead of bonds

Post by Valuethinker » Mon Feb 15, 2016 10:52 am

freebeer wrote:
Valuethinker wrote:
fsrph wrote:Anyone going heavily into CD's replacing bonds in their fixed income allocation?...
In light of what is happening in global financial markets:

- CDs are definitely preferred to bonds (as long as within FDIC limits for that institution)

- I would extend the duration of my CD portfolio...
A Bogleheads core principle is don't try to time the market: whatever you can forsee, the market has already priced in, and if you are making decisions based on what has recently happened (the Nisiprius-correct verb tense for "what is happening..."), you are highly likely to under-perform.

Yet many of us who wouldn't dream of doing this with our equities (myself included) try to time the market with our fixed income allocation. I don't see why it makes any more sense than for equities. In fact this thread had me warming to the idea that a minor shift into CDs made sense for me until reading the "in light of what is happening..." which I take as a blinking yellow warning light reminding me to "stay the course".
It's a totally fair point.

However the yield curve is upward sloping so extending duration is to your benefit over the long run-- that's the argument for bonds vs. cash in a portfolio (greater inflation and interest rate risk, but higher expected returns).

It's not so much that I can predict the future (I cannot, as you rightly note) it's that I fear it. Deflation (and negative interest rates) is no longer impossible in a US context.

At which point, it becomes about balancing risk. Many investors, particularly those in the drawdown phase, might find negative interest rates a very painful experience. What's your SWR if your bank account is paying -1%?

So whereas once I would have said "ladder of CDs to 5 years, max" I might now say "ladder to 7 years, or ladder to 5 years and barbell with some 10 yr CDs".

In other words, Japan is no longer impossible. I grew up in an era of double digit inflation, so emotionally I find that very difficult.

Someone once told me that military intelligence is not about what might happen so much as the worst that might happen. As in 19 men armed with boxcutters might hijack 4 jet planes and drive them into landmark buildings (but one group of passengers might resist, and, knowing the certainty of their own deaths, storm the cockpit and take the hijackers down with them, mission unfulfilled-- THAT I am sure was never in any "rock drill" of any national security exercise).

I can see a country going into deflation, and an Austrian corporal with a grudge against the world being appointed as Chancellor ...

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Re: Using CD's instead of bonds

Post by Johno » Mon Feb 15, 2016 11:42 am

The Dan wrote: Basically, if you buy treasury bonds at the steepest part of the yield curve, then you will accrue capital gains, in addition to your normal interest payments. This does not occur with non-brokered bank CDs.
As has been covered many times, this is only true if you make an apples to oranges comparison, albeit an apples to oranges situation that might occur. It assumes you buy and roll over bonds (via a fund, or rolling the bonds yourself, or rolling bond futures) to maintain a constant duration whereas you buy just one CD and allow the duration to shrink to zero before you buy another one. It's not true if you compare a ladder of CD's with a given average constant maturity to a fund/individual bonds/futures with the same constant average maturity. In that case the yield curve is the yield curve, and the 'roll effect' shows up in the CD ladder also, just in a different way.

For example my group of originally 5 yr maturity CD's has an average yield of ~2.50% and now an average maturity around 3 yrs. So instead of receiving 2.25% on 5 yr CD (approx best) when the 5 yr note is yielding 1.20%, 1.05% spread, I'm recieving 2.5% in 3 years when the 3yr note is yielding .89%, 1.61% spread. That's the same effect in a different form, it's because the 'prediction' of the upsloping curve when I bought the CD's hasn't come to pass. And when I bought the CD's the spread was actually less than 1%. It also accounts for the 'advantage' of the treasury fund, bonds or futures being marked to market and CD's not. As long as I'm not actually selling the treasuries/futures, the price gain is by definition offset by expression of a lower yield than initial. In CD case there's no mark to market price increase, but the fixed yield is that much further above the treasury curve if treasury rates decline.

The MTM characteristic is only relevant for instruments you actually sell. That might be some if you maintain fixed % in 'bonds' but it's not all, and it's not necessarily any depending your allocation method/philosophy. The money I have in CD's is money not going into stocks no matter what.

And of course this ever ongoing conversation isn't static. In fairly recent past iterations the best 5yr CD was more like only 0.75% above 5 yr note yield; also the repo rate was near zero but best savings account rates 1%. In that case putting 95% in savings account and using 5% to support a position in treasury futures gave a yield close to 1% over cash treasuries, beating the CD yield by a significant margin (though without the break option of a direct CD). Now CD to treas spread is over 1%, repo is at least .38% and best savings accounts only crept up to ~1.10%: the CD is at more of an advantage to cash+futures. But actually holding cash treasuries is virtually always beaten by the treasury futures plus savings account method, because it allows the individual to access the FDIC arb without the liquidity sacrifice in CD's and with only marginal increase in credit risk (whatever portion of the 5% you hold as actual cash, not in say a short term bond ETF, with the broker is at risk to their credit).

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Re: Using CD's instead of bonds

Post by Kevin M » Mon Feb 15, 2016 12:53 pm

patriciamgr2 wrote:Kevin M. a question. do CDs compound interest? Is there a particular interest calculation (APY?) that is the right one to use to compare CDs with bond fund yields? Thanks for sharing your expertise with the group. Regards
Hi Patricia,

The default for every direct CD I've purchased is for interest to be reinvested, in which case you do get the compounding effect. The APY reflects compounding, usually daily, but sometimes less frequently like monthly or quarterly. If you do not reinvest interest, you will earn the simple interest rate, which is less than the APY. They are related by this formula for daily compounding:

APY = (1 + i/365)^365 - 1

where i is the simple interest rate.

Usually you can find both interest rate and APY for the CD, but due to the rounded values they show, the formula may not give quite the right answer. For example, one of my CDs shows an interest rate of 2.22% and APY of 2.25% in my statement. We can check that:

(1 + 2.22%/365)^365 - 1 = 2.24% (rounded)

However, in my CD spreadsheet I have the rate as 2.221%, so I assume that more precise rate was provided when I bought the CD. Plugging in 2.221% to the formula above does generate a rounded value of 2.25%.

It's worth noting that interest reinvestment is not an option for brokered CDs, so you have reinvestment risk with brokered CDs but not with direct CDs with interest reinvested. I usually neglect to mention reinvestment risk in comparing brokered and direct CDs, since it is a relatively minor factor at the very low rates we've had in recent years, but the elimination of reinvestment risk is another advantage of direct CDs over brokered CDs (the largest advantage being the early withdrawal option).

I would say that comparing APY to YTM (yield to maturity) of a Treasury bond of same maturity is the best comparison, since you would earn the YTM of a bond if interest were reinvested at the YTM (which it may or may not be, since you can't reinvest the interest at that rate in a Treasury bond).

It's more complicated for a bond fund. For one, SEC yield is the average YTM of the bonds in the bond fund averaged over the previous month. Next, a bond fund has no maturity, so is more like a rolling bond ladder, and more thought has to go into comparing a rolling bond ladder to a single CD or bond.

The 5-year return of a single federally-insured 5-year CD or single 5-year Treasury bond is known with high certainty (some uncertainty for the CD due to possibility of bank failure, in which case you won't lose your money, but will have to reinvest in a new CD at an unknown rate, and some uncertainty in the Treasury due to reinvestment risk, but IMO, these risks are minimal); the 5-year annualized return will be the APY for the CD and very close to the YTM for the Treasury.

By contrast, the 5-year return of a bond fund has significant uncertainty, as I've already explained. So a good starting point in the comparison is to use the SEC yield for the bond fund (since it's a form of YTM), but you have to remember that the 5-year return (or 10-year return) could vary significantly from this. That's a function of the higher risk of the bond fund: you might earn more, or you might earn less.

So I think the best starting point for comparison is a Treasury of same maturity. If your bond fund has a higher SEC yield than a 5-year Treasury, then it is virtually by definition riskier than a 5-year Treasury. There's nothing wrong with taking more risk for higher yield if that's what you want to do, but as I've explained, I think you can combine CDs with bond funds in a more rational way to achieve a more optimum balance of risk and expected return; i.e., don't use bond funds that hold lots of Treasuries that you can beat handily with good direct CDs. Instead, target your bond fund holdings for exposure to the specific risks you want to take in return for the specific benefits.

I personally use bond funds that have more term risk than my CDs, and some credit risk, which is consistent with holdings in something like total bond fund. Someone who prefers to avoid credit risk, but take some term risk for the potential negative correlation with stocks in times of financial stress might want to hold a long-term Treasury fund.

An intermediate-term Treasury fund also provides some of this benefit, but not as much per dollar invested as the long term fund (in recent years at least), and all of the Treasuries in a 3-10 year Treasury fund, such as Vanguard's Intermediate-Term Treasury fund, have lower yields than even just a good 5-year CD (most recent yield of 10-year Treasury is only 1.74%). Of course for someone who prefers simplicity over optimization, the intermediate-term Treasury fund may be preferable as a single-bond-fund holding, due to the declining expected-return and higher volatility of extending maturity beyond 10 years.

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Re: Using CD's instead of bonds

Post by protagonist » Mon Feb 15, 2016 12:59 pm

fsrph wrote:Anyone going heavily into CD's replacing bonds in their fixed income allocation? I currently have approx 70% of fixed income in CD's. It's a lot of money. Here's why. Bond yields are so low, what's the 10 year treasury at 1.75%? Why wouldn't I take over 100 basis points? I have been selective in the CD's I chose (From Penfed, Northwest, Valor and NASA). The blended rate of all the CD's is 2.88%. Anyone doing something similar? Or and I missing some downside risk using CD's so heavily?

Francis
I have a higher %age of my fixed income in CDs than you do. I also have some in I-bonds. The only corporate bonds I own are part of an investment in FFNOX that I cannot sell for awhile for complex reasons. If I could, I would own no corporate bonds at all.

CDs have very little downside risk if they are purchased intelligently. They also have very little upside potential in real terms. I can live with that.

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Re: Using CD's instead of bonds

Post by Kevin M » Mon Feb 15, 2016 2:35 pm

whodidntante wrote:Some prefer bonds because of the negative correlation to stocks, which means as stock prices fall, there is a tendency for bonds to appreciate. That has occurred in the current downturn, for example. However, that doesn't apply under all market conditions.
All true statements (with the qualification that the negative correlation is not dependable, or as you say not "under all market conditions"), and already addressed in my analyses above. This is why it can be rational to hold both direct CDs and one or more bond funds, which is what I do and what the OP apparently does.

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Re: Using CD's instead of bonds

Post by Kevin M » Mon Feb 15, 2016 2:50 pm

Desert wrote: This might be the best post I've ever read regarding CD's.
Thank you! Although I've made the same points in many other posts, you never know what structure is going to work best for any particular person.
Desert wrote:I agree that the (small) free lunch available to individual investors via CD's is worth the additional effort.
Keep in mind that a (small?) 1 percentage point higher yield translates to roughly 5 percentage points more total return over 5 years and 10 percentage points over 10 years (of course more with compounding factored in). Just like with expense ratios, apparently small differentials in annual returns compound to significant differentials over time.

Another way to frame it is that 2% is 100% more than 1%, and also translates to a cumulative return that is about 100% higher (more with compounding). So roughly 10% vs. 5% over 5 years, and roughly 20% vs 10% over 10 years (more with compounding). Putting it in dollar terms may help; i.e., on $1M, earning $200K vs. $100K over 10 years.
Desert wrote:I've chosen to move all intermediate bond fund allocation to CD's, maintaining a small slice to LTT's for portfolio draw-down reduction in flight-to-safety scenarios. I currently hold 60% fixed, with 48% in CD's/IT and 12% LTT's. This approximates the duration of a 10 year treasury, with higher yield and similar interest rate sensitivity.
Sounds very rational to me.

Have you used your LTT to do any rebalancing into stocks lately? With a rebalancing band of +/- 5 percentage points, you may or may not have triggered rebalancing yet, depending on how much you hold in international stocks. With 40% in stocks, a decline of about 19% in the stock portion of your portfolio is required to trigger rebalancing using a +/- 5 percentage point band: +/- 5% Rebalancing Bands. But this assumes no change in bonds, and since your LTT are up significantly YTD, it would take a smaller drop in stocks to trigger rebalancing.

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Re: Using CD's instead of bonds

Post by Valuethinker » Mon Feb 15, 2016 3:00 pm

protagonist wrote:
CDs have very little downside risk if they are purchased intelligently. They also have very little upside potential in real terms. I can live with that.
If we have deflation then USD CDs for US investors still have significant upside. That's what is so worrying. If the world is going to negative nominal interest rates, then 2% on a 5 year CD is going to look very good.

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Re: Using CD's instead of bonds

Post by Valuethinker » Mon Feb 15, 2016 3:02 pm

gvsucavie03 wrote:A pre-retirement CD ladder seems to make sense to some degree. Prior to that, bonds are the better long-term investments. A CD ladder early on only seems to make sense for diversifying emergency funds and savings that will not be part of retirement accounts.

A savvy person might consider a 3-4% checking account and keep the savings portion seperate on your spreadsheet. Better yields than CDs and MMAs. Yes, you need to do a minimum number of debit transactions, but if savings is thoughtfully and carefully mixed with the everyday checking, most folks would easily hit the minimum each month. One I'm looking at is 3% with 10 debit transactions per month up to $15,000.
I don't know how US banking works, but how long will 3-4% pa interest rates persist if inflation falls to near zero?

Parts of the world have moved to negative interest rates. That's no longer impossible in the US- -whereas say 2 years ago I would have said it was practically impossible.

I can't give it a probability, but then I wouldn't have said negative interest rates were possible, either.

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Re: Using CD's instead of bonds

Post by protagonist » Mon Feb 15, 2016 3:06 pm

Valuethinker wrote:
protagonist wrote:
CDs have very little downside risk if they are purchased intelligently. They also have very little upside potential in real terms. I can live with that.
If we have deflation then USD CDs for US investors still have significant upside. That's what is so worrying. If the world is going to negative nominal interest rates, then 2% on a 5 year CD is going to look very good.
Which would also offer some balance against other investments that may lose value under that scenario.

People were upset with the performance of their I-bonds during the last period when the CPI-U declined and they were yielding 0% nominal. But when taken in context of deflation, that really was not so bad.

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Re: Using CD's instead of bonds

Post by Kevin M » Mon Feb 15, 2016 3:06 pm

longinvest wrote:I agree that brokered CDs are bonds, but bank CDs (usually with early withdrawal provisions) are cash (e.g. they have a non-fluctuating principal value).
You can keep calling direct CDs cash, but that doesn't make it true. It is a very misleading characterization, for reasons I'll elaborate on below.
longinvest wrote:IIf the SEC's intent was to compare bond coupons and rates on cash, maybe the SEC has forgotten about pre-1930 years. If the intent was to compare yields, then it is simply mistaken. If the intent was really to compare past returns, then the SEC was totally wrong; past 1-year returns on cash were sometimes higher than that of other asset classes (stocks and bonds).
The SEC statement is consistent with the charts we've all seen that compare the long-term returns of US stocks, US bonds, and US cash (typically Treasury Bills are used to represent cash). These charts clearly show that stocks have had by far the largest returns, and that bonds have beat cash by a fair margin.

This is why it's misleading to characterize good direct CDs with maturities of 5 years or more as cash. A good 5-year CD (direct or brokered) will almost certailnly earn more than a 5-year Treasury over the next five years (with the possibility of bank failure and the corresponding reinvestment risk requiring the "almost" qualifier). It will earn even more than a 10-year Treasury, and the 10-year Treasury often is used to represent "bonds" in long term comparisons (sometimes a 20-year Treasury or "government bond" is used).
longinvest wrote:It is my opinion is that nobody, not even the SEC, can predict* future returns.

* Note that no prediction is needed to know the nominal future value of a CD with compound interest on the day it matures. But, as soon as reinvestment is involved, even on a cash investment, one would have to guess future interest rates to predict a return.
Your footnote is important, since it directly contradicts your earlier statement with respect to direct CDs with interest reinvested. Further, reinvestment has a relatively minor impact at current low rates, so we can forecast the nominal return of a 5-year Treasury quite accurately (although not as accurately as for the CD). Similarly, we can forecast the 5-year real return of a 5-year TIPS quite accurately, again with some uncertainty due to reinvestment risk. Zero-coupon bonds can be used to eliminate reinvestment risk in nominal terms.

So I think it's simplistic and misleading to simply say that no one can predict future returns. It's quite easy to predict with a high degree of certainty that a 5-year CD with an APY of 2.25% or 2.50% will earn a significantly higher 5-year return than a 5-year Treasury with a yield of 1.20%.

It's far less certain with bond funds, due to the term risk inherent in having no maturity, which is an important consideration in making these trade-offs.

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Re: Using CD's instead of bonds

Post by freebeer » Mon Feb 15, 2016 3:09 pm

Valuethinker wrote:
freebeer wrote:
Valuethinker wrote:
fsrph wrote:Anyone going heavily into CD's replacing bonds in their fixed income allocation?...
In light of what is happening in global financial markets:

- CDs are definitely preferred to bonds (as long as within FDIC limits for that institution)

- I would extend the duration of my CD portfolio...
A Bogleheads core principle is don't try to time the market: whatever you can forsee, the market has already priced in, and if you are making decisions based on what has recently happened (the Nisiprius-correct verb tense for "what is happening..."), you are highly likely to under-perform.

Yet many of us who wouldn't dream of doing this with our equities (myself included) try to time the market with our fixed income allocation. I don't see why it makes any more sense than for equities. In fact this thread had me warming to the idea that a minor shift into CDs made sense for me until reading the "in light of what is happening..." which I take as a blinking yellow warning light reminding me to "stay the course".
It's a totally fair point.

However the yield curve is upward sloping so extending duration is to your benefit over the long run-- that's the argument for bonds vs. cash in a portfolio (greater inflation and interest rate risk, but higher expected returns).

It's not so much that I can predict the future (I cannot, as you rightly note) it's that I fear it. Deflation (and negative interest rates) is no longer impossible in a US context.

At which point, it becomes about balancing risk. Many investors, particularly those in the drawdown phase, might find negative interest rates a very painful experience. What's your SWR if your bank account is paying -1%?

So whereas once I would have said "ladder of CDs to 5 years, max" I might now say "ladder to 7 years, or ladder to 5 years and barbell with some 10 yr CDs".

In other words, Japan is no longer impossible. I grew up in an era of double digit inflation, so emotionally I find that very difficult.

Someone once told me that military intelligence is not about what might happen so much as the worst that might happen....
Sure, if by extending average duration you aren't trying to optimize expected total return (i.e. beat the market) but merely protect against possible downside risk then that's perfectly valid. But, TANSTAAFL: by implication you should expect less return in the expected case and are also exposed to other risks (inflation) so that means you will need to save more, work longer, etc., as a result of protecting against the scenario which the market-price consensus has deemed unlikely. And making this particular course adjustment right now smacks of recency bias to me which means it's even more likely to be a poor move.

longinvest
Posts: 3980
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Re: Using CD's instead of bonds

Post by longinvest » Mon Feb 15, 2016 3:23 pm

Kevin M wrote:
longinvest wrote:I agree that brokered CDs are bonds, but bank CDs (usually with early withdrawal provisions) are cash (e.g. they have a non-fluctuating principal value).
You can keep calling direct CDs cash, but that doesn't make it true. It is a very misleading characterization, for reasons I'll elaborate on below.
Your characterization is based on past returns (which have no guarantee to recur in the future). Mine is based on risk; in other words, on the fundamental characteristic of a non-fluctuating principal value (usually guaranteed).

Bonds and cash investments offer, some times, the possibility of calculating reasonable ranges of possible returns, due to their characteristics, and even precise returns on specific future dates. Liability matching uses these characteristics to reduce risk as much as possible. But, this fail as soon as an investor's plan is changed out of his control (job loss, etc.). This is where cash and bonds differ. Bonds, if cashed before planned, have not guaranteed principal value. Cash investments do.

So, I maintain my classification of bank CDs as cash, based on their non-fluctuating principal value.
Bogleheads investment philosophy | One-ETF global balanced index portfolio | VPW

dbr
Posts: 30812
Joined: Sun Mar 04, 2007 9:50 am

Re: Using CD's instead of bonds

Post by dbr » Mon Feb 15, 2016 3:46 pm

longinvest wrote:
So, I maintain my classification of bank CDs as cash, based on their non-fluctuating principal value.
What anyone classifies something as has no effect on what it actually does. Hopefully the merits of holding bank CDs are decidable on the facts rather than on what things are called.

Desert
Posts: 133
Joined: Thu Nov 11, 2010 7:21 pm

Re: Using CD's instead of bonds

Post by Desert » Mon Feb 15, 2016 6:53 pm

Kevin M wrote: Keep in mind that a (small?) 1 percentage point higher yield translates to roughly 5 percentage points more total return over 5 years and 10 percentage points over 10 years (of course more with compounding factored in). Just like with expense ratios, apparently small differentials in annual returns compound to significant differentials over time.

Another way to frame it is that 2% is 100% more than 1%, and also translates to a cumulative return that is about 100% higher (more with compounding). So roughly 10% vs. 5% over 5 years, and roughly 20% vs 10% over 10 years (more with compounding). Putting it in dollar terms may help; i.e., on $1M, earning $200K vs. $100K over 10 years.
Good point. That is quite a difference!
Kevin M wrote:
Desert wrote:I've chosen to move all intermediate bond fund allocation to CD's, maintaining a small slice to LTT's for portfolio draw-down reduction in flight-to-safety scenarios. I currently hold 60% fixed, with 48% in CD's/IT and 12% LTT's. This approximates the duration of a 10 year treasury, with higher yield and similar interest rate sensitivity.
Sounds very rational to me.

Have you used your LTT to do any rebalancing into stocks lately? With a rebalancing band of +/- 5 percentage points, you may or may not have triggered rebalancing yet, depending on how much you hold in international stocks. With 40% in stocks, a decline of about 19% in the stock portion of your portfolio is required to trigger rebalancing using a +/- 5 percentage point band: +/- 5% Rebalancing Bands. But this assumes no change in bonds, and since your LTT are up significantly YTD, it would take a smaller drop in stocks to trigger rebalancing.
I haven't hit a rebalancing trigger yet, but that's entirely because I buy trailing assets with new contributions. And even with this practice, I've come close. My 30% equity is split equally between TSM, SCV and EM. Most of my contribution money has gone into SCV and EM over the past year.

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