Bonds. Why? (vs. cds)

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Random Poster
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Re: Bonds. Why? (vs. cds)

Post by Random Poster »

peacelove wrote: Wed Sep 19, 2018 11:08 am Let's all go back to the original discussion. It seems like tangents abound. Why not just get an FDIC insured 3 yr CD at 3.01 % instead of a bond for our low risk portion of our portfolio?
Are there any municipal (i.e., federal income tax free) issued CDs?

I need bonds for portfolio stability, asset preservation, and semi-steady income, but I don't want (and definitely do not need) any federally taxable interest.

So I guess that is one reason to go with a (municipal) bond instead of a CD.
Admiral
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Re: Bonds. Why? (vs. cds)

Post by Admiral »

I would also add that many company-sponsored retirement plans do not offer CDs as an option. Bond funds, yes. CDs, not so much. That's not to say you cannot get brokered CDs in T-IRA accounts; you can. They are just generally less available in employer plans.
Ron Scott
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Re: Bonds. Why? (vs. cds)

Post by Ron Scott »

finite_difference wrote: Wed Sep 19, 2018 12:18 am I’d buy a bond fund or a CD, but I’d never buy an individual bond.
I have a bond ladder with about 30 munis left in it. Seems to work great. Why don't you like individual bonds?
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Re: Bonds. Why? (vs. cds)

Post by friar1610 »

peacelove wrote: Wed Sep 19, 2018 11:08 am Let's all go back to the original discussion. It seems like tangents abound. Why not just get an FDIC insured 3 yr CD at 3.01 % instead of a bond for our low risk portion of our portfolio?
Amen. And I think Dandy's post above does an excellent job of explaining the answer, along with a good real-life example.
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munemaker
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Re: Bonds. Why? (vs. cds)

Post by munemaker »

Thesaints wrote: Wed Sep 19, 2018 11:15 am CD, just like cash, have zero correlation with stock returns by definition.
That would not be true for brokered CDs where the value of the CD on the secondary market) rises and falls with interest rates, would it? Wouldn't they behave like treasuries, rising in value when rates fall and falling in value when rates rise?
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Re: Bonds. Why? (vs. cds)

Post by Thesaints »

munemaker wrote: Wed Sep 19, 2018 8:03 pm
Thesaints wrote: Wed Sep 19, 2018 11:15 am CD, just like cash, have zero correlation with stock returns by definition.
That would not be true for brokered CDs where the value of the CD on the secondary market) rises and falls with interest rates, would it? Wouldn't they behave like treasuries, rising in value when rates fall and falling in value when rates rise?
To keep things simple I'm referring to standard CD's. FDIC insured for most. Brokered CD's instead would fall into the "traditional" bonds category I mentioned
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Re: Bonds. Why? (vs. cds)

Post by Kevin M »

m@ver1ck wrote: Tue Sep 18, 2018 7:45 pm If we can assume that US interest rates are going to keep going up slowly through the next few years, why is better to invest in Bonds, vs. just investing in a CD ladder?

Do Bonds Yield more than CDs?
Ally has 2.5% CDs for a one year period, for instance (for a 25K minimum).
Is this for a taxable account or a tax-advantaged account, like an IRA? If in a taxable account, what are your marginal federal and state income tax rates? This is important to know because of the state tax exemption for Treasuries in a taxable account.

In my IRAs, I've mainly been buying brokered CDs in the 2-3 year maturity range. They have a higher yield than Treasuries of the same maturity, but that advantage as been shrinking. You get a decent yield premium for extending maturity to three years, but very little for going out further than that. At 1-year maturity, you'll get about the same yield for a Treasury as a brokered CD, but since Treasuries are more liquid, I'd go with Treasuries for 1-year maturity (or less) in an IRA.

In prior years, I was buying mainly 5-year CDs directly from banks and credit unions, as the yield premiums over Treasuries of same maturities were very large--my average premium was 1.1% (110 basis points), and some were as high as 150 basis points. And the early withdrawal penalties (EWPs) were mostly six months of interest. The yield premiums for direct CDs generally are much lower now, and the EWPs generally are one year of interest or more. Brokered CDs generally have been competitive with direct CDs in recent months, so I've been consolidating by transferring proceeds of maturing IRA CDs to a brokerage account, and buying brokered CDs.

In my taxable accounts, I'm buying mostly Treasuries with maturities out to two years. The state tax exemption gives me a higher taxable-equivalent yield (TEY) than CDs at my marginal federal and state tax rates of 27% and 8% (not itemizing). For example, a 1-year Treasury at 2.59% is a TEY for me of 2.91%, while a 1-year brokered CD is 2.55%. A 2-year Treasury at 2.81% is TEY for me of 3.16%, while best 2-year brokered CD yield is 2.90%.

The Treasury yield curve flattens out a lot beyond two years--you only get about 7 basis points more, 2.88%, than a 2-year at 2.81%. I don't consider that adequate compensation for the additional term risk for new cash. I accept that I'm taking on extra reinvestment risk by keeping new investments shorter-term, but I have other longer-term CDs and bond funds that hedge that.

Whether you use brokered CDs or Treasuries for your ladder, you have similar term risk, and essentially no credit risk as long as you stay within the FDIC insurance limits with CDs. However, brokered CDs generally have much higher bid/ask spreads than Treasuries, due to much lower liquidity, so I don't buy brokered CDs unless I almost certainly will hold to maturity. If the yields are close, I'd favor Treasuries due to much better liquidity.

Direct CDs can have less term risk if the EWP is small enough, since your downside is limited to the EWP. That's why I was favoring direct CDs when the yield premiums were high and the EWPs were low. If rates increase enough, you can do an early withdrawal from the direct CD, pay the relatively small penalty, reinvest in a new CD or a Treasury at the higher yield, and come out ahead at the end of the original term to maturity. You can't do this with Treasuries or brokered CDs.

A downside of direct CDs, especially if you have a large fixed income portfolio, is you must open accounts at multiple banks and credit unions to get the best yields and stay within the FDIC insurance limits (NCUA for credit unions). And then you're probably going to have to transfer out of that bank or credit union when the CD matures to get the best yield then.

If you don't mind the work, a really good direct CD deal now is a 15-month at NASA federal credit union at 3.25% APY. Some people have reported problems joining the credit union and opening the CD, but others have reported that it was quite easy for them. I personally decided against it, as I would earn only about $270 more than a 15-month Treasury after tax on $100K for 15 months. I probably would have jumped on this a few years ago, but have grown weary of joining multiple credit unions, and then having to transfer the money out at maturity; and the yield premium over the Treasury is only about 30 basis points, which is way less than my average of 110 basis points since late 2010.

Kevin
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munemaker
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Re: Bonds. Why? (vs. cds)

Post by munemaker »

Kevin M wrote: Wed Sep 19, 2018 9:27 pm
If you don't mind the work, a really good direct CD deal now is a 15-month at NASA federal credit union at 3.25% APY. Some people have reported problems joining the credit union and opening the CD, but others have reported that it was quite easy for them.
I just did this. Joining the NASA FCU (online), transferring the money from Vanguard MMF (ACH transfer) and buying the CDs (by phone) was easy. As stated, some others have experienced complications.
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Re: Bonds. Why? (vs. cds)

Post by Munir »

peacelove wrote: Wed Sep 19, 2018 11:08 am Let's all go back to the original discussion. It seems like tangents abound. Why not just get an FDIC insured 3 yr CD at 3.01 % instead of a bond for our low risk portion of our portfolio?
Good point. That seems an appropriate vehicle for funds one doesn't need for three years. If you want more liquidity and need the money sooner, MM Prime SEC yield is 2.11%. Bond funds cannot compare on a short-term basis.
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Re: Bonds. Why? (vs. cds)

Post by Kevin M »

Munir wrote: Thu Sep 20, 2018 11:56 am
peacelove wrote: Wed Sep 19, 2018 11:08 am Let's all go back to the original discussion. It seems like tangents abound. Why not just get an FDIC insured 3 yr CD at 3.01 % instead of a bond for our low risk portion of our portfolio?
Good point. That seems an appropriate vehicle for funds one doesn't need for three years. If you want more liquidity and need the money sooner, MM Prime SEC yield is 2.11%. Bond funds cannot compare on a short-term basis.
Per the points brought up in my reply just above, there could be several reasons to prefer a Treasury over a CD, and there may be reasons not to extend maturity even to three years, depending on your desired balance between term risk and reinvestment risk, and whether or not it's a taxable or tax-advantaged account.

In a taxable account, a Treasury may provide higher taxable-equivalent yield (TEY), or if you prefer to think about it in after tax terms, higher after-tax yield (ATY). For me, a 2-year Treasury provides higher TEY/ATY than a 3-year CD. The Treasury provides higher yield, less term risk, and much better liquidity.

Liquidity alone is one reason not to use only CDs for your fixed income. If your investment policy includes rebalancing into stocks if they fall too far below your target, then you want some fixed income with good liquidity for this. Brokered CDs have high bid/ask spreads, and direct CDs have an early withdrawal penalty (EWP), so these are not optimal for rebalancing. Treasuries have very low bid/ask spreads, and are more likely than not to increase in value if stocks tank (although this is not a certainty).

Some prefer the simplicity of bond funds. The Vanguard short-term Treasury Index bond fund would be my second choice over individual Treasuries out to 2-year maturity in a taxable account. Almost all holdings are 1-3 year maturity, with average maturity of about two years.

Some may have more concern about unexpected inflation, in which case TIPS or a TIPS fund could be preferable to either CDs or nominal Treasuries, at least for a portion of their fixed income.

In an IRA, or with no state income tax, you get much more additional yield for extending CD maturity from 1-year to 2-years than from 2-years to 3-years, and even more for extending from 0-year to 1-year. So one might prefer a 1-3 year ladder over just buying a 3-year CD, and as mentioned in my earlier reply, I would use Treasuries for the 1-year rung, as they have about the same if not slightly higher yield than a 1-year CD.

Kevin
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