Bonds vs. Cds Discussion

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mrwheelerdealer
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Bonds vs. Cds Discussion

Post by mrwheelerdealer » Wed Jun 25, 2014 4:59 pm

I went through a big portion of the threads on the cds vs. Bonds argument, but I just dont seem to understand the two sides. Everyone knows that theres only one direction interest rates can go in this environment, which means that anyone who buys bond funds right now is accepting that at some unknowable time in the future he will lose a portion of his principle when interest rates go up.

This is of course assuming someone invests in intermediate/ long term bond funds, but lets assume I would put my bond portion in vanguard short term treasuries. Thats right now yielding about 0.33%. In a savings account I can get around 0.85%. So that clearly is not sensible. Lets assume I invest in vanguard intermediate term treasuries. Thats yielding about 1.5% right now. In a 5 year fdic insured cds I can get 2.25% right now, with no risk of principle ( only small withdrawal penalty).

And even if you' 'll tell me that people like the way treasuries go up when the economy is in turmoil, it doesnt seem to me that that advantage is enough to make up for the significant decrease in yield and risk of principal.

Its interesting to me that in all the books ive read nobody really touches on the subject. It seems like a no brainer that shouldn't be long discussions on threads.Am I missing something Bogleheads?

Thanks
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ogd
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Re: Bonds vs. Cds Discussion

Post by ogd » Wed Jun 25, 2014 5:14 pm

mrwheelerdealer wrote:Its interesting to me that in all the books ive read nobody really touches on the subject.
This one is easy enough: the present situation with CDs yielding more than Treasuries is new and somewhat unexpected. I'm not aware of it having happened before for any length of time.
mrwheelerdealer wrote:Everyone knows that theres only one direction interest rates can go in this environment, which means that anyone who buys bond funds right now is accepting that at some unknowable time in the future he will lose a portion of his principle when interest rates go up.
Not everyone. E.g. I know Treasuries can go at least as low as 0.65%, having been there in May '13. So that's 1% less, or 5% of appreciation for our "counterbalance" argument below. With higher yields, the investor would lose principal temporarily, to be made back through higher yields within 5 years, so it's rather benign, money delayed rather than money gone. The only thing protecting CDs from the same amount of opportunity loss is having the early withdrawal option and being willing to use it, which is the one true free lunch in all of this.

The main reason to use Treasuries is mainly that they're easier to access. For example, you can buy them in a 401k which is where a lot of fixed income money resides. A secondary reason is that they're a good counterweight to equities because of the potential for appreciation and immediate accessibility (one click fund exchanges).

In general, I agree with you that CDs and savings accounts are a better deal right now and I would not hold short term Treasuries at all. But bonds still make sense in some circumstances.

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Re: Bonds vs. Cds Discussion

Post by weltschmerz » Wed Jun 25, 2014 5:59 pm

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Re: Bonds vs. Cds Discussion

Post by Call_Me_Op » Wed Jun 25, 2014 6:00 pm

mrwheelerdealer wrote:I went through a big portion of the threads on the cds vs. Bonds argument, but I just dont seem to understand the two sides. Everyone knows that theres only one direction interest rates can go in this environment...
The problem with your statement above is it's not true. In fact, that can never be the case.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Bonds vs. Cds Discussion

Post by Dandy » Wed Jun 25, 2014 6:36 pm

I don't think it should be all bond funds or all CDs. CDs currently offer some more than competitive yields coupled with FDIC guarantees. I just think they should be considered as part of many people's fixed income allocation. If an investor has a intermediate or long term investment horizon bonds funds should recover from interest rates so it should be more of a shorter term issue.

I like having some no loss of principal fixed income like CDs, Savings bonds, Stable Value funds - in this interest rate environment I just like having a bit more of an allocation to them. If your fixed income allocation is for stability of your portfolio so you can take most of your risk on the equity side - there really isn't a great argument not to have some CDs.

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Re: Bonds vs. Cds Discussion

Post by JamesSFO » Wed Jun 25, 2014 6:51 pm

mrwheelerdealer wrote: Everyone knows that theres only one direction interest rates can go in this environment
...
with no risk of principle ( only small withdrawal penalty).
Bonds CAN go down further OR they could stay the same. So everyone does NOT know there is ONLY ONE direction.

Also, CDs have principal risk, it's just that (a) people don't mark CDs to market and (b) because EW penalties are capped you aren't quite as fully exposed. That said, banks like Ally with formerly generous EW penalties have made them more onerous.

So the choice is not quite as clear.

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Re: Bonds vs. Cds Discussion

Post by acegolfer » Wed Jun 25, 2014 7:30 pm

Dear OP,

I looked up the 5-yr T-note yield and 5-yr CD rate from

http://online.wsj.com/mdc/public/page/2 ... asury.html
http://www.bankrate.com/

5-yr T-note yield = 1.692%
5-yr CD rate = 1.72%

Your numbers (1.5% vs 2.25%) are somewhat exaggerating. Your bank may offer you 2.25% 5-yr CD rate but it's not common. Nationally, CD rate and yields are about the same.

In addition, as someone mentioned, there are benefits of holding T-note over CD.

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Re: Bonds vs. Cds Discussion

Post by Doc » Wed Jun 25, 2014 7:46 pm

ogd wrote:The main reason to use Treasuries is mainly that they're easier to access.
I disagree. While access is an important consideration the main reason to use Treasuries is their negative price correlation to equities in periods of equity market disruptions. CD's don't have this attribute.

Each individual has to decide for their own situation which is more important: Yield of their FI portfolio - choose CD's. Or variation of their overall FI + equity portfolio - choose Treasuries. (But many time you can have some of each and be just fine.)
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Re: Bonds vs. Cds Discussion

Post by Sidney » Wed Jun 25, 2014 8:06 pm

Doc wrote:CD's don't have this attribute.
How do brokered CDs do?

Brokered CDs are really the only practical way to do significant volume with CDs. Treasuries have no volume issues either. But I have never really compared the price performance.
I always wanted to be a procrastinator.

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Re: Bonds vs. Cds Discussion

Post by ogd » Wed Jun 25, 2014 8:14 pm

Doc wrote:
ogd wrote:The main reason to use Treasuries is mainly that they're easier to access.
I disagree. While access is an important consideration the main reason to use Treasuries is their negative price correlation to equities in periods of equity market disruptions. CD's don't have this attribute.
Doc: if all your portfolio is in a 401k then I guarantee you they're easier to access :beer This may not apply to you, but integrated over all investors / forum members it's a big factor into why bonds are a topic (which the OP argues they shouldn't be).

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Re: Bonds vs. Cds Discussion

Post by Rob5TCP » Wed Jun 25, 2014 8:21 pm

I have bought several 3% from Pen Fed and 2.75/2.5 from various credit unions.
Some had 6 months withdrawal penalties and some had 12 months.
They made more sense to me than did buying bonds.

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Re: Bonds vs. Cds Discussion

Post by acegolfer » Wed Jun 25, 2014 8:26 pm

Doc wrote:
I disagree. While access is an important consideration the main reason to use Treasuries is their negative price correlation to equities in periods of equity market disruptions. CD's don't have this attribute.

Each individual has to decide for their own situation which is more important: Yield of their FI portfolio - choose CD's. Or variation of their overall FI + equity portfolio - choose Treasuries. (But many time you can have some of each and be just fine.)
You may think CD's don't have this attribute because you are not valuing the CD correctly.

When bond prices go up "in periods of equity market disruptions", the interest rates go down (I assume you already know this.) When interest rates decreases, the value of CD increases. (Do I need to explain this?)

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Re: Bonds vs. Cds Discussion

Post by acegolfer » Wed Jun 25, 2014 8:31 pm

Rob5TCP wrote:I have bought several 3% from Pen Fed and 2.75/2.5 from various credit unions.
Some had 6 months withdrawal penalties and some had 12 months.
They made more sense to me than did buying bonds.
I understand your logic.

However, when investing in bonds, ppl don't necessarily hold till maturity. Many investors sell bonds before maturity. Since they don't hold the bond till maturity, bond yield (to be exact, yield to maturity) is not a guaranteed return and hence they don't compare the yield with CD rates.

(If someone correctly points out that even when holding T-note till maturity, the yield is not a guaranteed return, I know what you are saying. http://www.bogleheads.org/forum/viewtop ... 0&t=141854)
Last edited by acegolfer on Wed Jun 25, 2014 9:24 pm, edited 1 time in total.

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mrwheelerdealer
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Re: Bonds vs. Cds Discussion

Post by mrwheelerdealer » Wed Jun 25, 2014 8:46 pm

JamesSFO wrote:
mrwheelerdealer wrote: Everyone knows that theres only one direction interest rates can go in this environment
...
with no risk of principle ( only small withdrawal penalty).
Bonds CAN go down further OR they could stay the same. So everyone does NOT know there is ONLY ONE direction.

Also, CDs have principal risk, it's just that (a) people don't mark CDs to market and (b) because EW penalties are capped you aren't quite as fully exposed. That said, banks like Ally with formerly generous EW penalties have made them more onerous.

So the choice is not quite as clear.[/quit

JamesSFO,

Do you mind explaining what marking to market is? Thanks
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mrwheelerdealer
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Re: Bonds vs. Cds Discussion

Post by mrwheelerdealer » Wed Jun 25, 2014 8:54 pm

acegolfer wrote:
Doc wrote:
I disagree. While access is an important consideration the main reason to use Treasuries is their negative price correlation to equities in periods of equity market disruptions. CD's don't have this attribute.

Each individual has to decide for their own situation which is more important: Yield of their FI portfolio - choose CD's. Or variation of their overall FI + equity portfolio - choose Treasuries. (But many time you can have some of each and be just fine.)
You may think CD's don't have this attribute because you are not valuing the CD correctly.

When bond prices go up "in periods of equity market disruptions", the interest rates go down (I assume you already know this.) When interest rates decreases, the value of CD increases. (Do I need to explain this?)
True that the inherent value of the cd goes up, but you cannot trade it on a secondary market for more. Therefore, the paper value is not going in the opposite direction of equities. I believe thats what doc means and indeed that's very valuable. (My point was is it worth the interest rate risk and a full percentage point of yield).
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Re: Bonds vs. Cds Discussion

Post by acegolfer » Wed Jun 25, 2014 9:09 pm

mrwheelerdealer,

I agree with you 100%. That explains OP's fallacy.

He said one should buy CD instead of bonds because CD rate is higher than bond yields. As you stated, bonds and CD are not the same product so one should not make investment decision solely based on rates.

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Re: Bonds vs. Cds Discussion

Post by ogd » Wed Jun 25, 2014 9:12 pm

acegolfer wrote:I agree with you 100%. That explains OP's fallacy.

He said one should buy CD instead of bonds because CD rate is higher than bond yields. As you stated, bonds and CD are not the same product so one should not make investment decision solely based on rates.
Priceless :D

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Re: Bonds vs. Cds Discussion

Post by Langkawi » Wed Jun 25, 2014 9:35 pm

ogd wrote:
acegolfer wrote:I agree with you 100%. That explains OP's fallacy.

He said one should buy CD instead of bonds because CD rate is higher than bond yields. As you stated, bonds and CD are not the same product so one should not make investment decision solely based on rates.
Priceless :D
Hilarious. Almost as funny as this:
acegolfer wrote:When interest rates decreases, the value of CD increases. (Do I need to explain this?)

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Re: Bonds vs. Cds Discussion

Post by JamesSFO » Wed Jun 25, 2014 9:52 pm

mrwheelerdealer wrote: JamesSFO,

Do you mind explaining what marking to market is? Thanks
So a bank CD (as opposed to a brokered CD) where you deposit $10K @ 2% on day 1. Now the next morning, interest rates go up to 3%, that same CD should be worth less because IF the CD was tradeable someone would no longer pay you $10K for the 2% CD.

Bonds and bond funds are marked to the current market price, or marked to market. With a bond fund (or bond), your $10K investment on day 2 goes DOWN in value on day 2 when interest rates go up because the market value of the bonds goes down.

It's very visible to you, but some of that same decrease in value you happened to your CD too you just aren't tracking the change.

See Wikipedia for more: http://en.wikipedia.org/wiki/Mark-to-market_accounting

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mrwheelerdealer
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Re: Bonds vs. Cds Discussion

Post by mrwheelerdealer » Wed Jun 25, 2014 10:00 pm

JamesSFO wrote:
mrwheelerdealer wrote: JamesSFO,

Do you mind explaining what marking to market is? Thanks
So a bank CD (as opposed to a brokered CD) where you deposit $10K @ 2% on day 1. Now the next morning, interest rates go up to 3%, that same CD should be worth less because IF the CD was tradeable someone would no longer pay you $10K for the 2% CD.

Bonds and bond funds are marked to the current market price, or marked to market. With a bond fund (or bond), your $10K investment on day 2 goes DOWN in value on day 2 when interest rates go up because the market value of the bonds goes down.

It's very visible to you, but some of that same decrease in value you happened to your CD too you just aren't tracking the change.

See Wikipedia for more: http://en.wikipedia.org/wiki/Mark-to-market_accounting
Got it thanks a lot. Do broker cds indeed ever make sense?
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Re: Bonds vs. Cds Discussion

Post by stlutz » Wed Jun 25, 2014 10:28 pm

Do broker cds indeed ever make sense?
They can. They are the least liquid of the options discussed here (T-notes, bank CDs, brokered CDs) so you do really need to seriously plan to hold to maturity. At times they can offer a nice yield premium over a comparable treasury. An investor should demand a yield premium over Treasuries to buy them--obviously everyone needs to decide from themselves. I do emphasize the phrase "at times." Simply buying a brokered CD because it's being sold is not a good idea. Tactically buying them when the pricing is good can be.

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Re: Bonds vs. Cds Discussion

Post by Doc » Thu Jun 26, 2014 10:56 am

There are two concepts here that get conflated.

1) How do the two types of FI react to a change in interest rate? In this case they behave similarly with their price change going in the opposite direction of the interest rate. If you hold the instrument to maturity both will return the payments initially promised when you purchased the security. If you choose or need to sell you still get back the promised value of the bond or CD. All you can accomplish is to be able to do some tax arbitrage by converting ordinary income into capital gain or loss.

2) How do the two types of FI react to an equity market disruption? Now we have an entirely different situation. Now you may need to sell in order to re-balance. In this flight to quality situation the Treasuries excel because a lot of (non-Boglehead) people are buying Treasuries and raising their price. The price you can get from a CD doesn't move and even brokered CD's price may move in the wrong direction. In '08 even TIPS moved in the wrong direction.

In order for anyone to assess the bond/CD question they first need to decide why they are holding this type of security at all. The answer is often give as for return dummy. Well if your reason is return only why would you want to hold any short term instrument at all when a longer term instrument gives you more money.

Remember bond traders can do their sums. They can even do discounted cash flow calculations. We are talking fixed income. The cash flow is a given. Barring default that instrument is going to give the promised return at the original discount rate whether you sell it or not. The fact that the YTM goes up or down some time in the future does not affect your return (at least for the original "duration").
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Re: Bonds vs. Cds Discussion

Post by Dandy » Thu Jun 26, 2014 12:58 pm

It's very visible to you, but some of that same decrease in value you happened to your CD too you just aren't tracking the change.


We have to be careful between a bank CD and a brokerage CD. A bank CD can be redeemed at initial purchase price less the early withdrawal penalty no matter what the post purchase interest rate does. Brokered CDs' value is directly affected by changes in interest rates.

Each fixed income product has advantages and disadvantages if you know them you can make wise decisions. It is rare to have a product that has been around for a long time that has no value under at least some circumstances. Cds seem to be either ignored/panned or thought of as a no brainer - the truth is -- it depends on the individual's circumstances and the rates/terms at the point of decision. Like all fixed income investments you need to look beyond the rate offered.

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