CDs Instead Of Bond Funds

Reader Question

What is your opinion of moving IRA savings from short term bond funds into insured CDs with terms comparable to the bond fund durations provided the interest rate on the CDs exceeds the SEC Yield on the fund? Seems like a no brainer to me, but would appreciate your opinion.

My Reply

I very much agree. Due to the Federal Reserve's monetary policy and the requirement -- or at least the desire -- of many market participants for ultimate safety in their holdings, today's US treasuries funds carry artificially low yields. But they also constitute much or even most of the holdings of broad bond index funds, which means  those broad bond index funds also have lower yield than they might have otherwise. Not to imply that CDs have particularly high yields these days, but it's not hard to find yields higher than what's available from US treasuries. And by investing in FDIC- and NCUA-insured CDs you don't sacrifice any safety.

I would strongly recommend looking for CDs with a relatively cheap option to break (say, penalty of 3-6 months' interest). That option could well end up being even more valuable than the excess yield in CDs relative to treasuries. It would allow you to abandon your relatively low-yielding CD for a much higher-yielding fixed income choice (CD or otherwise) should interest rates rise significantly in the coming years, before your CD is due. Regular bonds, such as US treasuries, of course lack this option and would fall in value if and when such a rise in interest rates occur. A 7-year treasury might lose around 12% in value if the prevailing interest rates on treasuries rise by 2% (200 basis points). Your CD would not suffer the same loss on paper, of course, but without the option to break it it would effectively be costing you just as much in missed opportunity costs. The option to break the CD would let you safely lock into the longest available maturity -- typically 7 or 10 years -- thus capturing highest available yield while still being protected from the future rise in interest rates.

Outside of IRA accounts I would also strongly consider I Savings bonds and maybe EE Savings bonds. The I Savings bonds are probably an even bigger no-brainer than CDs. Their inflation-tracking will likely deliver around 2% annual gain -- higher than the treasuries and many CDs, but with protection from unexpected inflation, with the same perfect safety, with deferred taxation, with a cheap and very valuable option to break after 1 year (and completely penalty-free after 5 years), and leaving more room in your tax-sheltered accounts for other investments. EE Savings bonds aren't quite as attractive since you'd have to wait 20 years for them to reach effective 3.5% yield, but that 3.5% would easily beat any of today's treasuries while still providing deferred taxation and cheap option to break early.

Finally, corporate and municipal bonds also have higher yields than corresponding maturity treasuries, but that spread has narrowed significantly since I started writing about it a year or so ago. So while they probably still represent a better deal than treasuries, it's no longer an obvious no-brainer due to their lack of treasuries-level safety.

One thing you do give up by going treasuries-free in your investments is some level of diversification. Should we have a repeat of 2008-2009 collapse even today's low-yielding treasuries will likely spike up in price at longer maturities. That would potentially allow you to sell them at a large profit and invest in other fixed income or even equity choices which will likely be quite cheap at the time. But neither a repeat of 2008-9 nor your ability to time things just right are all that likely to happen. I would gladly take the bird in hand of higher yield with equivalent safety and option to break in the form of CDs or US Savings Bonds over the two in the bush in the form of  US treasuries with unparalleled diversification at times of crisis.