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