How to compare Bond fund vs CD?

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KnowNth
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How to compare Bond fund vs CD?

Post by KnowNth » Wed Sep 11, 2019 12:34 pm

GS bank offers 5 year CD with APY 2.6%
Vanguard Intermediate bond ETF BIV yield 2.4%, with average duration of 6.1 years.

Assuming one doesn't need this money within 5 years, how do you compare them?

Would bond fund perform better when interest rates drop while CD perform better when interest rates increase?

I used to think the difference must be negligible, but BIV has a one year return of 12.57% with the recent interest rates dropping.

sharx
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Re: How to compare Bond fund vs CD?

Post by sharx » Wed Sep 11, 2019 1:17 pm

I'm interested in the answers too, but I'm not sure about the "CD performs better when interest rates increase" part, because you have to factor in the opportunity cost of not being able to get into a higher interest CD without a penalty. Similar in concept to holding a bond to maturity vs holding a bond fund.

dbr
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Re: How to compare Bond fund vs CD?

Post by dbr » Wed Sep 11, 2019 1:24 pm

It might be better to think of the comparison in terms of risk. In this case we mean by risk that the return is variable or uncertain. So a bond fund is more variable in return than a CD. The result, at you say, could be more or less.

The response in return of changing interest rates for a bond fund is complicated, in particular as interest rates change all the time. You can study the concept of duration to understand the ideas, but most of the examples people come up with are too simple. Possibly a generalization is that for time short compared to the duration falling interest rates would increase the return, but for times long compared to the duration you want rising interest rates to increase the overall return.

dbr
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Re: How to compare Bond fund vs CD?

Post by dbr » Wed Sep 11, 2019 1:25 pm

sharx wrote:
Wed Sep 11, 2019 1:17 pm
I'm interested in the answers too, but I'm not sure about the "CD performs better when interest rates increase" part, because you have to factor in the opportunity cost of not being able to get into a higher interest CD without a penalty. Similar in concept to holding a bond to maturity vs holding a bond fund.
That is correct. As time goes by the drop in NAV is offset and exceeded by the opportunity to earn higher interest rates on the bonds.

Scooter57
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Re: How to compare Bond fund vs CD?

Post by Scooter57 » Wed Sep 11, 2019 5:15 pm

You can still find higher CD rates at some credit unions. Check out depositaccounts.com.

If the CD has a 6 month interest withdrawal penalty and rates go up significantly you come out ahead with the CD. I had no difficulty in breaking my 2.20% 5 yr CDs and reinvesting them at 3.55% some months ago. The penalty was 6 mos interest or 1.10% but now I have locked in the 3.55% rate for 5 years, again with 6 month early withdrawal penalties. Bond fund owners could not capture that brief spike in rates.

Another benefit is that the CDs can be set up as Payable on Death (POD) accounts and pass to heirs without probate. They also terminate on my death and return the full principal plus accumulated interest which the fund does not. If the fund's NAV has dropped due to rising rates your heirs get less principal andmight have to hold for years to recover.
Last edited by Scooter57 on Fri Sep 13, 2019 2:01 pm, edited 1 time in total.

jdilla1107
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Re: How to compare Bond fund vs CD?

Post by jdilla1107 » Wed Sep 11, 2019 7:21 pm

The SEC yield is actually 2.02% on BIV. You want to compare with the SEC yield, not the distribution yield. The SEC yield can be seen here:

https://investor.vanguard.com/etf/profile/BIV

So, the CD rate is better than you are thinking.

The CD could under perform BIV in the future for the following reasons:

- CDs are not liquid. You can't re-balance with them. If you break needlessly, you lose.
- When you hold a 5 year cd for 3 years, you are then holding a 2 year cd. Did you really want to hold a 2 year cd? BIV will sell bonds as they age and buy new longer term bonds. This means with BIV you are always holding a "7 year bond". Always holding a 7 year bond is better if interest rates drop. Every day you hold the CD, your duration is dropping.
- BIV has a maturity of 7 years instead of 5 years, which will do better if interest rates fall further.

The CD will win if everything stays the same or interest rates increase enough where breaking the CD makes sense.

Personally, I own both CDs and bond funds. I would recommend doing some of each.

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jeffyscott
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Re: How to compare Bond fund vs CD?

Post by jeffyscott » Thu Sep 12, 2019 9:21 am

In addition to interest rate risk, that fund also has some default risk as it is 40% corporate bonds.

The more appropriate comparison for the 5 year CD would be a 5 year treasury, which has about a 1.6% yield or a treasury fund, which would also have a much lower yield than a 5 year CD. If, based on that comparison of 1.6% vs. 2.6% for the CD, you would not buy the treasury (or treasury fund) over the CD, I can not see any reason why you would buy an intermediate bond index fund over the CD, since more than 1/2 of the index fund is those same treasuries.

If you want to mix in the higher yield of corporate bonds and are not willing to accept the low yields of treasuries, it would make more sense to do so by putting 60% of the money in the CD and 40% in a corporate bond fund, rather than to put 60% in treasuries and 40% in corporate via the intermediate bond index. I would assume that VICSX is basically the same as the 40% of BIV that is in corporates.
Time is your friend; impulse is your enemy. - John C. Bogle

Topic Author
KnowNth
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Re: How to compare Bond fund vs CD?

Post by KnowNth » Fri Sep 13, 2019 12:28 pm

Thanks all! Learned quite a lot.

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