CD Rates Falling, But Yield Premiums Still Attractive

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Kevin M
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CD Rates Falling, But Yield Premiums Still Attractive

Post by Kevin M »

A blog post with my latest thoughts on the current CD environment: CD Rates Falling, But Yield Premiums Still Attractive. Hope it's useful and informative for some of you.

Kevin
If I make a calculation error, #Cruncher probably will let me know.
bowtie
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by bowtie »

yes, thank you. Thinking about some CD options, so this was a good bit of information - good to note that about the reduction down to 1.75 in 2 cases.
Chicago60
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by Chicago60 »

Kevin, excellent and helpful post as usual. I really think of you as the fixed income guru on this site. My fixed income portion of my asset allocation is, and has for 15 years been, almost exclusively in I-Bonds and 5 year CD ladders, using Ken Tumin's site as my primary resource to purchase new CD's at maturity. I am earning 2.40-3.00% on each 5 year CD. Your posts have persuasively argued against using bond funds.

My thinking has somewhat changed, as I now believe I need to eliminate taxable interest income in order to convert a sizeable tIRA to a RothIRA, and in years when I choose not to convert, generate capital gains harvesting to the top of the 15% tax bracket. So, as each of my CDs mature, I intend on using the proceeds to buy muni bond funds. With your expertise in the fixed income field, I was wondering if you (or others) had a view on what muni bond funds (or ETFs) you'd suggest, and why given these circumstances.

Thanks, in advance.
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by Kevin M »

Glad you found the blog post useful.
Chicago60 wrote:Your posts have persuasively argued against using bond funds.
I'm not against using bond funds. I just prefer to limit my term risk, especially when there's much more potential downside than upside for taking the risk, and I prefer to target my term risk and credit risk so I'm being compensated by adequate expected return. So at current low rates, I want no more than about 25% of my fixed income exposed to term risk (and in my case, some credit risk), and I don't want to own bond funds that hold Treasuries with yields that I can easily beat with good direct CDs of the same or shorter maturity. This is why I personally don't use Total Bond fund or an intermediate-term Treasury fund with Treasuries at such low yields.

A typical counterargument is that Treasuries tend to go up in value when stocks go down. Aside from fact that this hasn't always been the case, and it's easy to envision a rising rate environment in which stocks and Treasuries both lose value, if I wanted a pure, term-risk-only hedge like this, I'd use a dab of a long-term Treasury fund, since long-term Treasuries have tended to go up much more than intermediate-term Treasuries in flight-to-safety scenarios. Since I don't care about short-term fluctuations, I'd limit an investment in long-term Treasuries to just enough to meet expected rebalancing needs, since I'd only expect long-term benefit in the form of a rebalancing bonus. Otherwise, why would I hold a 20-year Treasury, or a fund that holds them, with the 20-year Treasury yield at about 1.8%, which is less than I can easily get in a 5-year CD with much less term risk.

Then people will say that long-term Treasuries are too risky. My counter to this is that the very popular Vanguard Total Bond Market Index fund has more than 15% of its bonds in maturities greater than 10 years, and more than 12% in maturities greater than 20 years. I'd rather keep 10%-15% of my fixed income in long-term Treasuries specifically for rebalancing into stocks in a flight-to-safety scenario, and keep up to 85%-90% in CDs that have higher yields than most of the Treasuries in TBM. Higher yield, less risk, and higher rebalancing bonus potential.

Personally I haven't been able to bring myself to buy Treasuries, since yields always have seemed too low relative to good CD rates or to investment-grade and tax-exempt bond funds. Of course if you bought long-term Treasuries when the 10-year yield was in the 3% ballpark in early 2014, you have been very nicely rewarded, since the term risk has paid off as rates have dropped to their recent historical lows, with yields in the same ballpark as mid-2012.

Although I haven't been holding Treasuries, the potential for yields to go even lower is one reason I've been keeping 25%-30% of fixed income exposed to term risk in intermediate-term and long-term investment-grade and tax-exempt bond funds. Credit risk hasn't really been penalized over the last five years--you can even say it's been rewarded if you compare returns of Vanguard intermediate-term bond funds--so these funds have allowed me to benefit some from the rewards to term risk over the last 5-6 years, while earning an average premium of over 100 basis points (over Treasuries of same maturities) with the bulk of my fixed income in CDs held to maturity.

I tend to shift a little more out of bond funds when yields start hitting historic lows, and a little back into them as yields go higher. Lately I've shifted a smidge more out of bond funds, especially long-term bond funds. Call it market timing or call it rebalancing--it's what floats my boat.
Chicago60 wrote:My thinking has somewhat changed, as I now believe I need to eliminate taxable interest income in order to convert a sizeable tIRA to a RothIRA, and in years when I choose not to convert, generate capital gains harvesting to the top of the 15% tax bracket. So, as each of my CDs mature, I intend on using the proceeds to buy muni bond funds. With your expertise in the fixed income field, I was wondering if you (or others) had a view on what muni bond funds (or ETFs) you'd suggest, and why given these circumstances.
I get where you're coming from, and this type of thing is another reason I keep some fixed income in bond funds--specifically tax-exempt bond funds in taxable accounts. I have to say though that I recently trimmed my tax-exempt fund bond holdings for reasons discussed above. I personally own Vanguard intermediate-term and long-term California tax-exempt bond funds, since I'm a California resident. I used to own some of the national tax-exempt bond funds too, but decided that I didn't have enough in tax-exempt bond funds to warrant diversifying my California muni-bond risk, so I sold my remaining shares in those funds last year, and used the proceeds partially to buy more CDs, and partially to add to my CA muni-funds.

If you've worked through the numbers, and are convinced that the conversions and tax-gain harvesting are worth moving into fixed-income with lower risk-adjusted expected returns, then I'd just carefully consider how much term risk you think is worth taking with yields at historic lows and prices at historic highs. My inclination would be to take minimal term risk in something like Vanguard Limited-term Tax-Exempt bond fund.

However, if you want to bet more on rates staying low or dropping further, then an intermediate-term tax-exempt fund would be an option. I'd consider using a state fund if in a high-tax state, and otherwise the intermediate-term national fund. Of course other than California, the state funds are all long-term, so you're taking even more term risk in them.

I must admit that it's hard to give up the juicy tax-free distribution yields of the intermediate-term and even long-term California muni funds, which have consistently been well above the SEC yields in recent years. We were having a forum discussion about this in early 2015, with yields at then-historic lows and prices at then-historic highs, and some posters argued that the distribution yield premium over SEC yield could not persist with the then-current conditions. However, looking at historical yields, I've seen that distribution yields tend to move slowly, so I decided not to sell all my shares of these funds. Now here we are with prices even higher than they were then, and the distribution yields for these two funds more than twice the SEC yields! This is why I recently further trimmed my holdings of these funds rather than selling all my shares.

Unless we're in for a very long period of low rates, which some believe we are, the piper will eventually have to be paid, and the juicy distribution yields will be offset by falling prices as yields increase. That's when it will be very comforting to have the bulk of my fixed income in direct CDs, knowing that I can pay a small penalty to do an early withdrawal and reinvest at higher rates.

Also, are you holding CDs in your IRAs? If not, the 7-year 3% CD at Andrews FCU is outstanding, so I would strongly consider doing an IRA transfer to buy that CD (and hope the rate holds). If you're holding stocks in your IRAs, then shifting some to CDs would open up taxable space to hold more stocks, which should have minimal negative impact on your conversions and tax-gain harvesting, the only downside being that the qualified dividends will eat up part of your 0% capital gains tax bracket (in the 15% statutory tax bracket).

Hope this helps!

Kevin
If I make a calculation error, #Cruncher probably will let me know.
Chicago60
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by Chicago60 »

Thanks immensely for the detailed thoughtful response. This helps me greatly.

I am convinced, based on my calculations, that I need to transfer assets generating taxable income into other assets--first step is maturing CDs to the right muni bonds, and the second step is to analyze which ETFs should be sold (and in what year) to purchase more tax efficient ETFs.

Due to our tax bracket, I have owned a fair amount of MUB, and have recently been looking at VWIUX as the likely place to invest my maturing CD assets (none of which is in my IRA), but VMLUX is something that has not been on my radar, and now requires further investigation and thought. Vanguard does not seem to have any state-specific (Illinois) funds for us.

Again, very much appreciate your time.
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by Kevin M »

Chicago60 wrote: <snip> first step is maturing CDs to the right muni bonds
Keep in mind that there is an implicit tax on muni bonds in the form of reduced yield. Assuming that muni bonds are priced to be competitive in the 25% tax bracket, if you are in the 15% tax bracket you are earning less than a competitive risk-adjusted yield on them. So you might want to run some after-tax scenarios with CDs vs. AAA (or perhaps AA) munis of same maturity, including your conversions and tax-gain harvesting, to see if the munis are really helping you in the way you think they are.

Larry Swedroe has mentioned that even for wealthy clients good CDs are sometimes more attractive than muni bonds, especially for shorter maturities. If this is true for a wealthy person (assume in a tax bracket of 33% or higher), then it almost certainly is true for someone in the 15% tax bracket.

Kevin
If I make a calculation error, #Cruncher probably will let me know.
carolinaman
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by carolinaman »

Thanks Kevin for the informative post and for keeping us current on the best CD rates. I increased my CDs holdings at Andrews this week. I now hold 40% of my AA in CDs, all at 3%, ranging from 3 to 7 year maturities. Holdings are at Andrews, Northwest FCU and Penfed. I would not have known about any of those great deals without your and other Bogleheads posts. It pays to be part of this forum. :D
student
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Re: CD Rates Falling, But Yield Premiums Still Attractive

Post by student »

Thanks so much for the post. I got a nasty surprise when I tried to purchase a CD from Barclays yesterday.
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