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Bonds vs. CDs
Old 11-18-2007, 10:24 AM   #1
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Bonds vs. CDs

Trying to do my asset allocation homework and have not yet learned why someone would put money in bonds rather than cds. Is it a matter of time frame; locking in good return for a long time? Doesn't seem so, as i recall several authors (4 pillars?) saying that the premium for long term bonds was not high enough for the aditional risk. Return? PenFed's recent 6.25% 3 year cds had a better return than the bond funds i looked at. Non-correlation with stocks? Don't i recall that bond return and stock return dropped together recently? In the short term, cd rates are fixed, I have no idea what new issue cd rates do in a stock market downturn. Anyway - can someone explain to me in simple terms why it is not better to have your money make as much money as possible at all times, that is, why it's better to invest in bonds rather than shopping the CD rates? What am i missing?
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Old 11-18-2007, 10:56 AM   #2
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I have asked this question before (regarding using MM vs govt bonds to fulfill the fixed income portion of an AA) and the answer I got was that for a brief period a few years ago govt bonds paid more...

Also treasury bond interest is exempt from state income tax.
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Old 11-18-2007, 12:12 PM   #3
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A bond's total return is a function of yield when you buy the bond. So, if you're holding to maturity, it makes sense to go for the highest yield assuming you're taking no more risk.

But if you're not holding till maturity, a bond's price will increase when yields fall. That's what "asset allocators" look at when they're looking at correlation and returns on an annualized basis. You don't get that with CDs or money markets.

In terms of individual bonds vs bond funds, good summary here:

FundAdvice.com - Paul Merriman: 10 reasons I favor bond funds
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Old 11-18-2007, 12:16 PM   #4
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Originally Posted by calmloki View Post
Trying to do my asset allocation homework and have not yet learned why someone would put money in bonds rather than cds. Is it a matter of time frame; locking in good return for a long time? Doesn't seem so, as i recall several authors (4 pillars?) saying that the premium for long term bonds was not high enough for the aditional risk. Return? PenFed's recent 6.25% 3 year cds had a better return than the bond funds i looked at. Non-correlation with stocks? Don't i recall that bond return and stock return dropped together recently? In the short term, cd rates are fixed, I have no idea what new issue cd rates do in a stock market downturn. Anyway - can someone explain to me in simple terms why it is not better to have your money make as much money as possible at all times, that is, why it's better to invest in bonds rather than shopping the CD rates? What am i missing?
You must be missing the same thing I've been missing.
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Old 11-18-2007, 12:21 PM   #5
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CD's usually have a interest penalty that you have to pay for its full duration if you yank your money out. Except for ibonds which have a small penalty in the first 5 years, and some other govt bonds that have an initial year or so where you cant cash the bond out or will pay a penalty, you can sell bonds anytime after that. If its during a time of dropping interest rates, you'll probably get more for the bond than its face value.

In a market where rates are rising or topping off, and you can get cd's that are at or above the prevailing interest rate, and you probably wont need to cash it out...a cd makes great sense.

In a market where rates are falling or unlikely to go higher, and you can get bonds that after taxes pay better than cd's, go with a bond or bond fund.

If you think the CPI will spike in the near future, buy tips.

Given that the internet has really opened up the cd market, made it easy to buy them, and makes every offering easy to find and buy by anyone, anywhere, rates have really become competitive. Its tough to beat a 5-7 year ladder of 5.xx and 6.xx% cd's. Thing is, you have to be able to figure out where you're striking the rate plateau and buy in before it drops. And hope it doesnt go a lot higher and forces you to sell and take a 3-6 month interest penalty.

Like equities, this is another place that diversification can be a good friend.
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Old 11-18-2007, 12:31 PM   #6
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Originally Posted by twaddle View Post
In terms of individual bonds vs bond funds, good summary here:

FundAdvice.com - Paul Merriman: 10 reasons I favor bond funds
Nice summary - thanks for posting.
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Old 11-18-2007, 12:37 PM   #7
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Thats a good article.

Quote:
Our suggested monthly income portfolio gets you into four funds (Short-Term Investment Grade, GNMA, High-Yield Corporate and Long-Term Corporate Bond)
But I wouldnt do that.
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Old 11-18-2007, 12:40 PM   #8
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The total return of a CD is the interest it pays. The total return of a bond fund is the combination of dividends and capital gains (and losses). A CD has no chance of producing capital gains (or losses).

I'll give an extreme recent case. If you bought the Vanguard Inflation Protected Securities fund (VIPSX) or the exchange-traded fund TIP in mid-June 2007 and sold it today, you would have made a total return of about 10%. The S&P500 is down about 4% in the same time period. A CD would have returned about 2% to 3% in the same time period.
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Old 11-18-2007, 12:45 PM   #9
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Yeah, but if you bought it in mid 2005 and sold in mid 2007, you'd have lost about 10% on vipsx vs a 40% gain in the s&p500 and a little more than 10% on commonly available 5 year cd's.

Back in '04 you could have lost 7% in about a month on vipsx.

Bonds can have a little more volatility than most people imagine.
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Old 11-18-2007, 12:51 PM   #10
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YBonds can have a little more volatility than most people imagine.
Exactly. Bonds are not necessarily "safe". I added the concept of capital loss to my previous post.
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Old 11-18-2007, 01:02 PM   #11
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Exactly. Bonds are not necessarily "safe". I added the concept of capital loss to my previous post.
There is an important difference between a capital loss for a bond vs a capital loss for a stock.

Bonds are guaranteed to recover their loss if held to maturity (assuming no defaults, of course).

The same applies to capital gains. Those gains are guaranteed to go away if you hold to maturity. I'll say it again: the total return on a bond held to maturity is function of the yield at the time of purchase.

The same applies to bond funds, but the concept of "maturity" is a little fuzzy when applied to funds. To get a measure of the potential future volatility of a bond fund (or individual bond), you want to look at duration.
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Old 11-18-2007, 01:58 PM   #12
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But if you're not holding till maturity, a bond's price will increase when yields fall. That's what "asset allocators" look at when they're looking at correlation and returns on an annualized basis. You don't get that with CDs or money markets.
I am starting to winder if this isn't only received wisdom, based on flimsy data. (More accurately, I am beginning to state this publically.) The calculator you posted yesterday in effect argues against any portfolio function for bonds, other than to be an asset class that won't be down when stocks are. CDs fill that need better than bonds. The late 60s through 70s periods that seemed to be such a killer in fact saw rising bond yields (falling bond prices) at the very time stocks were falling and inflation was increasing.

Plus, current yields on FDIC insured CDs are quite a bit better than on comparable maturity US treasuries.

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Old 11-18-2007, 02:08 PM   #13
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I agree (with what I think you're saying). The annual returns and correlations used by the asset allocation crowd is sort of a silly way to look at bonds unless you really buy into the rebalancing concept, in which case it makes some sense.

If I have a choice between a CD with a 6% yield and a treasury bond fund with a 5% yield, I'll take the CD every time.

My only use for bond funds is for junk bonds, where you benefit from diversification, and short-term money market funds for convenience.

And then there are CPI-linked bonds, which I don't think most banks offer.
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Old 11-19-2007, 04:27 AM   #14
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if you think when its time to renew your cd's rates will be lower than go with bonds. if your looking for some quick gains if rates drop go with bonds if you intend to sell and take those gains. otherwise stay with cd's.
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Old 11-19-2007, 11:16 AM   #15
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Two advantages of a bond fund over CDs: (1) you don't need to watch and re-ladder a bond fund since it doesn't mature, (2) your money generally isn't locked up for a set period with withdrawal penalties.

I love actively investing my stock portfolio and find it worthwhile. I don't like having to keep track of CD's or T-Bills to ensure that it always remains invested -- especially when the difference in returns is pretty small.
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Old 11-19-2007, 12:36 PM   #16
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Anyway - can someone explain to me in simple terms why it is not better to have your money make as much money as possible at all times, that is, why it's better to invest in bonds rather than shopping the CD rates? What am i missing?
'Cause I'm super frickin' lazy. I could just earn comparable rates as CD's through VFSUX. I guess the opportunity cost to go shopping around is just to high for me, not to mention that I'd rather have all my investment stuff at one place, not multiple banks/CU's. DW uncle recently passed and had this kind of stuff everywhere. It took forever for his fam to go through it all and figure out how to consolidate.

Anyway, there have been several prior conversations on this subject I linked to here.

- Alec
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Old 11-19-2007, 01:00 PM   #17
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And then there are CPI-linked bonds, which I don't think most banks offer.
Actually, some banks offer CPI-linked CDs. But the ones I have seen are not such a great deal compared to TIPS.
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Old 11-19-2007, 05:30 PM   #18
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Scott Burns has written quite a few articles about CD and Bond ladders that I like.

Go to Dallas Morning News | News for Dallas, Texas | Scott Burns: Columns 2007 (free registration required) then down the page along the right side under Readers and Reports click the Yield Ladders link.

Personally, I keep less than a year in a MM, about a year in a short-term bond fund, and for the balance of my non-equity investments I use a 5 year Treasury ladder, with bonds (usually TIPS) acquired once a year at original issue, and ideally held to maturity.

The advantages of treasury bonds over a CD ladder include:
  1. When fear, uncertainty, and doubt descend on the world markets, the value of my treasury bonds go up, just like they have done recently.
  2. If for some reason I need my cash back early, I figure I have at least a 50/50 chance of being able to sell my bonds for a profit. Either point #1 applies, or the stock market is doing well and I can sell stocks instead of bonds! With CD's, there is always a penalty for early withdrawal. You never win.
  3. No state income taxes on treasuries.
  4. Rock bottom expenses. (None if held to maturity.)
  5. Even less liquidity risk than an FDIC insured account.
  6. Unlike bond funds, individual bonds have a maturity date.
  7. Unlike bond funds, no unexpected capital gain distributions.
Bond funds do have some advantages, which is why I have some money in bond funds.
  1. Bond funds are very useful for small dollar amount transactions.
  2. Bond funds are useful for modest account balances.
  3. Bond funds are a great way to play with risky bonds which require diversification.
Unfortunately, bond funds usually have difficulty overcoming their many expenses on a risk and tax treatment adjusted basis compared to individual treasury bonds.

It is certainly true that from time to time the news is full of "bond yields fell today as traders rushed into the safe haven of treasuries." When that happens, CD yields will temporarily be more attractive than bond yields. However, most of the time I find the best deals at treasury auctions.

I have never purchased a savings bond, though I wish I had done so back when the I-bonds were yielding a wonderfully huge premium on top of inflation. At current levels, they just don't seem very attractive.
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Old 11-19-2007, 06:14 PM   #19
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It is certainly true that from time to time the news is full of "bond yields fell today as traders rushed into the safe haven of treasuries." When that happens, CD yields will temporarily be more attractive than bond yields. However, most of the time I find the best deals at treasury auctions.
Right now, today, CD rates up to 3 years or so pay as much as 150bp over treasuries-and this is brokered CDs, so they are usually an 1/8 to a 1/4 point lower yielding than ones you can find on your own.

For me, unless there is an extreme need for liquidity CDs win now.

Ha
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Old 11-19-2007, 06:24 PM   #20
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sold a few of my bond funds today. nice little capital gain of 2-3% on most not including the interest i got. ill buy a few cd's for a bit and see where rates go next. if they roll higher again ill rebuy bonds.
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