CD vs Treasury Spread

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aristotelian
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CD vs Treasury Spread

Post by aristotelian » Wed Dec 12, 2018 8:07 am

Does anyone know of a website that tracks the spread between brokered CD's and equivalent Treasuries?

With the quasi-inversion, the 5 year is sitting at 2.72%, while CD's are at about 3.5%, a .78% spread. That seems like a lot for the same duration risk and credit risk. CD's would seem to be a slam dunk for an individual bond investor. Am I missing something?

I bought a 5 year CD a few months ago at 3.3%, and if I remember correctly, the Treasury was above 3% at that time.

I have only been following interest rates for a short time so I am curious if someone tracks this, or how this compares historically.

StopIroningShirts
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Re: CD vs Treasury Spread

Post by StopIroningShirts » Wed Dec 12, 2018 8:13 am

CDs are provided based on the funding needs of banks. The banks have 3, 5, and 7+ year fixed rates their offering to their customers at a higher spread.

Treasuries are based on the funding needs of the government. The government is spending the money.

CDs usually pay a higher rate, especially those issues by smaller community banks because they don't have the same liquidity charge as a brokered CD you buy through Fidelity, Vanguard, ect.

Today brokered CDs look like a no brainier at three and five years vs going with a treasury bond

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Blueskies123
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Re: CD vs Treasury Spread

Post by Blueskies123 » Wed Dec 12, 2018 8:26 am

If you are with Fidelity then they show this information

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aristotelian
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Re: CD vs Treasury Spread

Post by aristotelian » Wed Dec 12, 2018 10:53 am

Blueskies123 wrote:
Wed Dec 12, 2018 8:26 am
If you are with Fidelity then they show this information
I can easily determine the current spread. I am interested in seeing how the current spread compares historically.

mindbogle
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Re: CD vs Treasury Spread

Post by mindbogle » Mon Jun 10, 2019 2:15 pm

I've been tracking direct CD to Treasury spreads for about the last 1.5 years and thought this might be interesting to some, especially with the recent sharp change in Treasury yields.

This first chart shows 5-yr direct CD APY versus 5-yr constant maturity Treasury yield since the beginning of 2010 until 6/7/2019. The "maximum" 5-yr direct CD series was constructed by averaging the APY's for the two highest offerings from the following banks, when available: Ally, Synchrony, Barclays, Capital One, Goldman Sachs (now Marcus), and Discovery. The data comes from various internet sources (including Deposit Accounts) before 2018, and then my own collection of bank rates since.

As one might expect, this chart shows that the bank rates are quite a bit smoother than Treasury yields, and tend to lag by 3-9 months. For period shown, CD APY's have been on average about .65% higher than Treasury yields.

The second chart includes the rate spreads, i.e. the difference between the maximum CD APY and treasury yields of the same maturity, for 1-yr, 3-yr, and 5-yr CD's. I omitted 2-yr and 4-yr so as to increase readability of the chart.

Throughout most of 2018, the spreads were close to zero, and at times negative, as the bank rates were slow in keeping up with the big rise in Treasury yields during that period. But now, as yields have fallen dramatically, the spreads for the 3-yr and 5-yr are very positive (1% and 1.2% respectively) and have not been this high since 2012 and 2013. Regards, MB

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Last edited by mindbogle on Wed Jun 12, 2019 6:14 pm, edited 4 times in total.

Day9
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Re: CD vs Treasury Spread

Post by Day9 » Mon Jun 10, 2019 2:45 pm

FDIC insured CDs are almost as secure as treasury notes so what explains the spread? Brokered CDs can be traded before they mature. The difference is the treasury market is the most liquid market in the world next to forex, whereas brokered CDs are relatively illiquid. So you pay a premium to hold treasuries. This is why after 2008 treasuries went up a lot more than brokered FDIC insured CDs.

The $250k FDIC CD limit has workarounds and is only infeasible for medium to large institutional investors. I think that this is a limit to arbitrage and partly explains the spread.

I think 5 year CDs are a great core fixed income investment, especially when there is a good spread over equivalent duration treasury.
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ivk5
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Re: CD vs Treasury Spread

Post by ivk5 » Mon Jun 10, 2019 3:04 pm

Day9 wrote:
Mon Jun 10, 2019 2:45 pm
The $250k FDIC CD limit has workarounds and is only infeasible for medium to large institutional investors. I think that this is a limit to arbitrage and partly explains the spread.
This is the explanation I’ve heard. IOW banks need to pay higher rates to compete for more limited supply of retail deposits. Not sure it’s provable, but at least plausible.

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Re: CD vs Treasury Spread

Post by trueblueky » Mon Jun 10, 2019 3:32 pm

Treasuries are exempt from state income tax. CDs are not. While I believe that difference is obscured by other, larger differences, it is real and measurable for an individual selecting which to purchase.

We use tax-equivalent yield in discussing municipal bond funds vs other bond funds. Why not here?

mindbogle
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Re: CD vs Treasury Spread

Post by mindbogle » Tue Jun 11, 2019 1:01 pm

trueblueky wrote:
Mon Jun 10, 2019 3:32 pm
We use tax-equivalent yield in discussing municipal bond funds vs other bond funds. Why not here?
Good point. If you are looking for an apples-to-apples comparison in effective yields, then not only do you have to account for taxes, but also for the structural differences between a coupon-bearing treasury bond and a "zero coupon" CD with a put option. So spot treasury yields would be more equivalent to CD APY's. The put option can be valued probabilistically using binomial trees, but of course would vary between CD's depending on the ewp, and I don't have history on ewp's.

But all of that would be unnecessary precision I think to make the point of my chart, which is just to show the relative changes in spreads over time. Plus I'm lazy :-).

Regards,

MB

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jeffyscott
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Re: CD vs Treasury Spread

Post by jeffyscott » Tue Jun 11, 2019 2:31 pm

aristotelian wrote:
Wed Dec 12, 2018 8:07 am
Does anyone know of a website that tracks the spread between brokered CD's and equivalent Treasuries?

With the quasi-inversion, the 5 year is sitting at 2.72%, while CD's are at about 3.5%, a .78% spread. That seems like a lot for the same duration risk and credit risk. CD's would seem to be a slam dunk for an individual bond investor. Am I missing something?

I bought a 5 year CD a few months ago at 3.3%, and if I remember correctly, the Treasury was above 3% at that time.

I have only been following interest rates for a short time so I am curious if someone tracks this, or how this compares historically.
FWIW, about a year ago I started brokered CDs (mostly secondaries) in an IRA that I had rolled over and then starting in January also have bought some in an HSA. I estimated the spread that I got for each and it has ranged from 0.13% to 0.95%, with average of 0.54% (dollar weighted is lower at 0.43%). The remaining term at time of purchase has ranged from 4 months to 5 years. Obviously a very small sample over a very short period of time.

If it were in a taxable account, I would lose about 1/2 of that average spread, based on the average yield of them being 3.13% and state tax rate 7.5%, so would lose 0.23%.
Time is your friend; impulse is your enemy. - John C. Bogle

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laidback_and_relaxed
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Re: CD vs Treasury Spread

Post by laidback_and_relaxed » Wed Jun 12, 2019 8:32 am

Relative to the short end of the curve, keep in mind the fixed purchase date structure of CDs if your only purchasing new (usually commission free vs purchasing on the open market where there are commissions to be paid). Banks offer CDs with future purchase dates that start the clock ticking for interest calculation purposes, usually days and weeks in the future, after putting the offer out. This results in higher reported effective yields for short term CDs than Treasuries. You can get higher effective yields on Treasuries by putting you money to work for you sooner, purchasing Treasuries that will start paying interest immediately. Your CD offer will sit on a shelf for a few days or weeks before getting filled. Then there's the recent Fed intervention in the short end, tilting CDs with higher rates. It takes Banks a few weeks or months to catch up to the Fed with regards to short term rates.

JackoC
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Re: CD vs Treasury Spread

Post by JackoC » Wed Jun 12, 2019 9:57 am

trueblueky wrote:
Mon Jun 10, 2019 3:32 pm
Treasuries are exempt from state income tax. CDs are not. While I believe that difference is obscured by other, larger differences, it is real and measurable for an individual selecting which to purchase.

We use tax-equivalent yield in discussing municipal bond funds vs other bond funds. Why not here?
Probably because state tax rates vary widely even at a given income, with a non-negligible portion of US investors in zero income tax states, besides often varying by income like federal. But as example best 5 yr direct CD was 3.40% APY at (my) 6.37% NJ tax rate is 3.18% 'treasury equivalent', still a massive spread over 1.92% APY 5 yr note, for basically the same credit risk, not counting the significant value of the put option represented by the ability to withdraw early with penalty. The best offering right now has a 1 yr interest EWP so that option isn't as valuable, but with a 6 month penalty that option could be more valuable than the NJ tax penalty at 22bps pa, and while a few threads here over the years have explained quantifying that, it's generally ignored also, as are usually the value of issuer call options investors are *short* in significant quantity in TBM or muni funds. If, that is, tying up money for 5 yrs fits the liquidity need of a given 'layer' of one's fixed income portfolio. Keeping in mind that virtually nobody would ever have to sell *all* their fixed income to rebalance to a given stock %, very unlikely even 1/2 of it.

The simple bottom line is that direct (in particular) CD prices are not efficient, so there's no reason to twist oneself into a pretzel trying to explain why there must be some difference in risk that justifies the spread when it's as wide as now. It's not efficient. 3.40% govt risk on 5 yr money (with a put option on top!) would disappear in a micro second in the professional market as everyone jumped on it, taxes shmaxes. :happy But they can't or it's too small (FDIC limit on govt gtee) to be worth it.

[edit to add, depositaccounts.com gives 3.40% but that provider Connexus has lowered the rate to 3.35% on their site, doesn't change the basic point]

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jeffyscott
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Re: CD vs Treasury Spread

Post by jeffyscott » Wed Jun 12, 2019 3:04 pm

laidback_and_relaxed wrote:
Wed Jun 12, 2019 8:32 am
Relative to the short end of the curve, keep in mind the fixed purchase date structure of CDs if your only purchasing new (usually commission free vs purchasing on the open market where there are commissions to be paid). Banks offer CDs with future purchase dates that start the clock ticking for interest calculation purposes, usually days and weeks in the future, after putting the offer out. This results in higher reported effective yields for short term CDs than Treasuries. You can get higher effective yields on Treasuries by putting you money to work for you sooner, purchasing Treasuries that will start paying interest immediately. Your CD offer will sit on a shelf for a few days or weeks before getting filled.
That's one of the reasons I have gone with secondary, can buy at a better yield (net of $1 per $1000 commission) than new and they settle in 2 days.

Even with short-term treasuries, with secondary they settle in one day rather than waiting around for an auction. Today I had some cash to deploy and happened to see there is an auction for 1 and 2 month bills tomorrow, but settlement would not be until the 18th.
Time is your friend; impulse is your enemy. - John C. Bogle

mindbogle
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Re: CD vs Treasury Spread

Post by mindbogle » Thu Jun 13, 2019 4:55 pm

JackoC wrote:
Wed Jun 12, 2019 9:57 am
Probably because state tax rates vary widely even at a given income, with a non-negligible portion of US investors in zero income tax states, besides often varying by income like federal. But as example best 5 yr direct CD was 3.40% APY at (my) 6.37% NJ tax rate is 3.18% 'treasury equivalent', still a massive spread over 1.92% APY 5 yr note, for basically the same credit risk, not counting the significant value of the put option represented by the ability to withdraw early with penalty. The best offering right now has a 1 yr interest EWP so that option isn't as valuable, but with a 6 month penalty that option could be more valuable than the NJ tax penalty at 22bps pa, and while a few threads here over the years have explained quantifying that, it's generally ignored also, as are usually the value of issuer call options investors are *short* in significant quantity in TBM or muni funds. If, that is, tying up money for 5 yrs fits the liquidity need of a given 'layer' of one's fixed income portfolio. Keeping in mind that virtually nobody would ever have to sell *all* their fixed income to rebalance to a given stock %, very unlikely even 1/2 of it.
Here's my stab at adjusting current spread (6/13/2019) for both Treasury yield tax-equivalence and direct CD option value:

5-yr Treasury YTM = 1.83%
5-yr Direct CD rate = 3.00% (as defined in earlier post above)
-> Unadjusted Spread=3.00%-1.83%=1.17%

Assume a hypothetical investor with Fed marginal tax rate (f) of 22%, and State marginal tax rate (s) of 7%.

Then tax-equivalent Treasury yield adjustment using this post by Kevin M:

TEY adjustment=YTM*((1-f)/(1-f-s) - 1)= 1.83%*(.78/.71-1)=.180%

As for the CD option value, I model the CD as a zero coupon bond with Bermuda put option, using BDT algorithm, assuming rate volatility (sigma) of 5% monthly, current CD rate curve, and 5 years to expiration:

EWP=0 days: Option value=.325%
EWP=60 days: Option value=.264%
EWP=90 days: Option value=.237%
EWP=150 days: Option value=.190%
EWP=183 days: Option value=.168%
EWP=270 days: Option value=.119%
EWP=365 days: Option value=.080%
EWP=540 days: Option value=.036%

So, let's say the hypothetical investor chooses a 5-yr CD with an EWP of 150 days:

Adjusted spread = CD APY+ CD Option Value - Treasury YTM - TEY adjustment = 3.00% + .190% - 1.83% - .180% = 1.18%

Difference between unadjusted and adjusted spreads = .01%

Conclusion: with the not unreasonable hypothetical assumptions made above, the CD option value and tax-equivalent Treasury yield adjustments are (coincidentally) approximately the same magnitude and opposite sign, and thus tend to cancel each other out in the spread. The adjustments will obviously vary with personal tax circumstances and CD opportunity set, and so might be important in atypical cases.

Regards,

MB

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