3 Reasons To Invest In CDs Instead Of Bonds In Very Low Interest Rate Environments

2012 November 26
by Kyle Bumpus
from → Investing And Investments

These types of “should you invest in x instead of bonds for income since interest rates are so low” posts have been popping up all over the internet recently. With current treasury yields being what they are (currently 0.16% for 6 months, 0.29% for 2 years, 0.70% for 5 years, and 1.70% for 10 years according to Morningstar), I can certainly understand the desire to reach for yield (dangerous as it might often be). In this case, though, I think yield-reachers may have a decent alternative: high yield CDs.

Keep in mind, I don’t plan to follow this strategy myself. I’m a long-term investor and I believe that while investment-grade bonds probably don’t currently represent a great deal for the money, I will be compensated in the long run if rates rise because my interest payments will automatically be reinvested in higher-yielding securities along the way. That said, switching to CDs is certainly a valid strategy for those concerned about near-term drops in principle.

Why CDs Instead Of Bonds?

The Fed has kept interest rates artificially low in an effort to boost the economy for a number of years now. While initially welcomed by most investors (the drop in rates brought a nice capital gains windfall for most bond investors, after all!), savers and especially the elderly who depend on interest-bearing assets to pay their living expenses are really hurting: it’s hard to afford nice vacations on 1% interest rates when you’re used to 4-5%. This puts income investors in a bind because the natural tendency to reach for yield in a portfolio is usually accompanied by a similar increase in risk, a fact usually (in my experience) not fully appreciated by yield-reachers. Result? They lose more than expected in a bear market and blame the market for “cheating them” rather than blaming themselves for investing beyond their risk tolerance. Fortunately, there’s a vehicle that allows you to significantly increase yields without increasing risk much at all: FDIC-insured CDs.

Three Reasons To Consider CDs Over Bonds Right Now

  1. CDs Currently Yield Almost Twice As Much As Treasuries With Similar Maturities - Surprised? According to Bankrate.com, FDIC-insured CDs currently yield about twice (or more) their treasury counterparts, at least up into the 5 year range. Why settle for 0.70% over 5 years (Treasury) when you could get 1.4% in a CD with no additional risk?
  2. You Don’t Have To Take On Any Extra Risk - If U.S. Treasuries are the safest investments on the planet, FDIC-insured CDs and bank accounts are a very close second. Both are backed by the full faith and credit of the U.S. Government. It’s hard to envision a scenario where FDIC-insured CDs are at risk but U.S. Treasury bonds are not. But wait, don’t higher yields usually signify higher risk? Not in this case. The discrepancy between what Treasuries pay and what CDs pay is largely due to market segmentation. Treasuries tend to be bought by large institutions such as mutual funds, insurance companies, and corporate finance departments in amounts measuring in the billions. CDs, on the other hand, tend to be bought by small investors. A pension fund wouldn’t want to own a CD because it wouldn’t benefit from FDIC insurance the way an individual would. Since FDIC insurance makes pretty much all CDs the same, they have to compete for deposits on interest rates alone, which tends to drive them up. Treasuries, on the other hand, have no obvious competition. There are simply no other no-risk options in the market. There are plenty of LOW-risk options out there, but no other truly risk-free asset. Hence, the U.S. Treasury can get away with paying less on its debt obligations whereas the banks can’t. You and I have plenty of other options. Your neighborhood pension fund doesn’t.
  3. Your Principle Is Safe Even If Interest Rates Rise – The down-side of bond funds is that as interest rates rise, their principle will fall. Yes, those interest payments will be re-invested in increasingly higher-yielding bonds and yes, you’ll eventually come out ahead, but this could take years. For short-term protection, there’s no beating an FDIC-insured CD. You are guaranteed 100% of your principle when it matures. Individual bonds have this advantage as well, it’s true, but as we saw above, the only comparably-risky bonds out there, U.S. Treasuries, yield much less than CDs right now.

But Of Course There’s A Downside…

Sadly, there’s no such thing as a free lunch. CDs do have one significant downside relative to bonds: liquidity. Specifically, CDs aren’t all that liquid unless you’re willing to sacrifice a few months’ worth of interest payments to redeem a CD early. The good news is there are plenty of CDs out there with relatively minor early-redemption penalties, on the order of 3-6 months’ worth of interest. What it means, though, is you can’t continually redeem your CDs early and reinvest at higher rates and expect to still come out ahead. If interest rates shoot up by 2-3% over the next year or so, it will probably be worth the penalty. On the other hand, if interest rates rise only a little you could potentially end up in a situation where you’re locked into a lower-paying CD because paying the early-redemption penalty would wipe out any potential gains from switching. Thus, I recommend either sticking to relatively short-term CDs (probably under 2 years) or constructing a CD ladder at 6-month or 1-year intervals.

Now, let’s simplify things a bit with a few rules-of-thumb.

CDs Instead Of Bonds If…

  • Preservation Of Principle Is Your Most Important Criteria - If you absolutely, positively must have 100% principle protection, CDs are likely your best bet.
  • You Want The Absolute Highest Rates – There are few scenarios where an all-bond portfolio  is going to out-perform an all-CD portfolio on a risk-adjusted basis over the next year or two. If you don’t mind monitoring interest rates and acting accordingly, you’ll probably end up slightly better off in CDs at the moment.
  • You Don’t Mind Doing A Bit Of Extra Work – The internet has made investing in CDs really easy, but nothing beats the simplicity of holding your entire portfolio in one place (Vanguard for me). Splitting up your fixed-income portfolio amongst 2 or 3 or 7 CDs at different banks online will cost you perhaps an hour of your time per year. That’s not much, but I’m really lazy.

Bonds Instead of CDs If…

  • You Have A Very Long Investment Horizon – If your investment horizon is 30 years and your bond portfolio had an average duration of 5 years, you’re going to come out ahead even if interest rates rise. You could probably squeeze out an extremely small additional bit of yield by switching to CDs in the short term (ignoring any taxes you may have to pay on the sale), but it’s probably not going to be worth your time. It is only when your investment horizon is short relative to  fixed income portfolio’s duration that you’re likely to see significant long-term gains from this strategy.
  • You Value Simplicity – When it comes to investing, laziness is often a virtue. The desire to tinker is often a strong one and there’s nothing wrong with resisting the urge. Keep it simple and stay the course.
  • You Rebalance Relatively Frequently – Rebalancing into CDs at various financial institutions isn’t much extra work if you only do it once every year or so, but if you rebalance more frequently it can begin to be a real pain.

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2 Responses
  1. 2012 November 26

    Kyle – You’re writing on one of the most important investment topics today because investors are pouring billions into bonds at just the wrong time. Bond yields are at historical lows (reward) and bond prices at historical highs (risk). The only place I disagree with you is buying bonds if you have a 30 year investment horizon. The yield is still too low. Yes, will eventually recover on a nominal basis but not after considering inflation and taxes. With a 30 year horizon I would still stick to CD’s and try hard to make yourself buy a few dividend stocks! Thanks for great information!

  2. 2012 November 28

    I overall agree. CDs should still be part of your portfolio, BUT (and this is a big one) the FED is boxed into a corner. They cannot raise rates otherwise the debt would explode. They are buying a minimum of $45B long term bonds per month with no end in sight.

    So I honestly don’t expect the FED to raise rates anytime in the near future (maybe with a new FED chief)

    The only reason rates will rise is because of bond vigilantes.

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