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CDs vs Total Bond Fund after 15 months
Old 05-27-2015, 09:54 PM   #1
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CDs vs Total Bond Fund after 15 months

I was going to comment in the "When to get back in to bond funds?" thread, but this might deserve it's own thread...

Way back when in early 2014 I remember not being happy with bond fund yields. The consensus, everywhere, was against bonds, not unlike today. At the same time, PenFed was offering a 5-year CD at 3%. I spent a lot of time reading analysis about CDs vs bond funds and a blog posting with good analysis convinced me that yes, the CDs will perform better than the bond funds. I went through the hassle of transferring funds from my IRA to PenFed to buy the CDs.

Lately I've been trying to consolidate and have been pondering if buying the CDs was really worth the extra hassle. To determine the answer is simple: run the numbers. Of course, it's only been 15 months, so the bond fund numbers can change, but I thought I would share my results.

I purchased a $30,000 CD on 2/5/2014. The value on 5/18/2015 is $31,189.21. An increase of 3.96%.

If I purchased Vanguard's Total Bond Fund (VBTLX) instead, the value on 5/18/2015 would be $31,394.97. An increase of 4.65%.

Note that I used 5/18/2015 since that's when interest is posted for the CD. After 15 months, it's a better performer than CDs.

Of course that can change. We'll see. If there's interest (pun time!), I can periodically update the thread and we can see how this progresses over 5 years.

I will say that for my situation I would rather own the bond fund than the CDs. Not enough to break the CDs - that would be silly - but in 45 months I expect I'll be transferring the funds away from PenFed.

[Edited to remove bond dividend accrual reference]
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Old 05-27-2015, 10:05 PM   #2
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Quote:
Originally Posted by kiki View Post
.....Note that I used 5/18/2015 since that's when interest is posted for the CD. The bond fund would be worth slightly more, since it would have accrued interest over the 18 days. So even with the slight disadvantage for the bond fund, after 15 months, it's a better performer than CDs.....
The NAV of the bond fund on any given day includes accrued interest on the underlying bonds.
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Old 05-27-2015, 10:28 PM   #3
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The NAV of the bond fund on any given day includes accrued interest on the underlying bonds.
Whoops, rookie mistake. I was thinking of MM funds which pay out interest when you sell since the NAV is fixed. Thanks for the correction!
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Old 05-27-2015, 10:50 PM   #4
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Putting all of your money in CD's is not investing. You should own a bond fund and a stock fund. Understanding How Stocks and Bonds Work Together
You're actually taking on more risk by being 100% in bonds.
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Old 05-27-2015, 10:53 PM   #5
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Originally Posted by pb4uski View Post
The NAV of the bond fund on any given day includes accrued interest on the underlying bonds.
For Bond ETFs that's true, but for bond mutual funds, the accrued dividend is held separately and does not show up in the NAV. Otherwise, the NAV would drop when the monthly dividend was paid out.

For bond mutual funds, it is true that one gets the pro-rated share of the monthly dividend depending on how many days in a month one holds shares. If one sells all their shares, then one will see that accrued dividend paid separately to you.
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Old 05-28-2015, 12:47 AM   #6
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Putting all of your money in CD's is not investing. You should own a bond fund and a stock fund.

You're actually taking on more risk by being 100% in bonds.

Owning CDs is investing and I'd never recommend having 100% bonds. I don't care much for bonds or CDs, but allocate 10-20% of my portfolio to them to reduce volatility.

I'm sharing this analysis because I thought it was interesting that over the last year, owning a total bond fund has done just fine when compared to a generous 3% CD. This might not hold out for the entire 5 years (we'll see!). Considering how many are out there harping against bond funds - and yes, I know they'll be hit some when rates increase - so far there's been no material effect.
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Old 05-28-2015, 12:55 AM   #7
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For Bond ETFs that's true, but for bond mutual funds, the accrued dividend is held separately and does not show up in the NAV. Otherwise, the NAV would drop when the monthly dividend was paid out.



For bond mutual funds, it is true that one gets the pro-rated share of the monthly dividend depending on how many days in a month one holds shares. If one sells all their shares, then one will see that accrued dividend paid separately to you.

Interesting. I took a quick look at a bond fund I sold and didn't see the corresponding accrued dividend paid out. I need to double-check my records, since I must have overlooked it.

A quick google search found the following from the bogleheads site: "[Note that if you sell all of your bond fund shares in the middle of the month, you will receive as proceeds the value of your shares (calculated as number of shares times net asset value) plus a separate distribution of the accrued income dividends.]"

Found here: http://www.bogleheads.org/wiki/Net_asset_value
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Old 05-28-2015, 04:25 AM   #8
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Originally Posted by kiki View Post
Owning CDs is investing and I'd never recommend having 100% bonds. I don't care much for bonds or CDs, but allocate 10-20% of my portfolio to them to reduce volatility.

I'm sharing this analysis because I thought it was interesting that over the last year, owning a total bond fund has done just fine when compared to a generous 3% CD. This might not hold out for the entire 5 years (we'll see!). Considering how many are out there harping against bond funds - and yes, I know they'll be hit some when rates increase - so far there's been no material effect.
bonds have been taking it on the chin since jamuary as investors have already bid up the yields on bonds. while the fed has not changed the short end yet , the longer end where bonds are has already changed .

my vanguard total bond fund admiral shares has a total return of .81% including interest year to date. my fidelity total bond has returned 1.62% ytd .

my fidelity corporate bond fund is just around 1% . so bond returns are down so far from the norm.
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Old 05-28-2015, 07:05 AM   #9
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There is also the dynamic between CDs and bond funds what you can do in the interim.

Some CDs allow you to get out for a marginal fine. So when rates go up you can actually shift away.

Bond funds you can usually sell at any moment, but you can incur a big loss unless you stay (roughly) as long as the equivalent CD. Conversely, it can also have a big gain instantly where with a CD you'll have to wait it out.

This for me tilts the scale towards CDs if interest rates are relatively low, and towards bond funds if they are highish.

Which one actually wins out in the short to middle term (say, 5 - 10 years) is pretty impossible to know for sure. If you just keep them side by side disregarding the flexibility and short term dynamics they should even out in the long run though?
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Old 05-28-2015, 07:50 AM   #10
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I think this kind of analysis is very valuable and frequently do it myself to evaluate the investment decisions I've made. After all, if I'm never willing to critique my own decisions, I'll never be able to learn from experience and avoid repeating a mistake.

Nevertheless, I find it far from clear that the small lead that VBTLX currently holds over the CD will hold up over the entire five year term. I gather that the CD has a 3% yield compounded quarterly for 20 quarters. At the end of the five years it should be worth $34,835.52. What VBTLX will be worth then is, of course, unknown, but I see that the total bond fund currently has an SEC yield of only 2%. Taking the 31,394.97 value on 5/18 and compounding a 2% monthly yield for the remaining 45 months of the five year term, I estimate that VBTLX will only grow to about $33,838 by the time the CD matures, even if the bond fund doesn't suffer any decline in NAV. So, my money would be on the CD beating the bond fund by about $1,000 over the entire five years, with the big unknown being how fluctuations in NAV will change the final value of the hypothetical investment in VBTLX.

The underlying problem with extrapolating 15 months of returns to a full five years is that a lot of VBTLX's current advantage is based on increases in NAV from 2/2014 through 1/2015. Bonds were rallying strongly for this entire 12 month period. But (somewhat perversely) the big bond rally was bound to hurt future returns because dividends were getting reinvested at higher and higher prices (resulting in lower and lower yields). Ironically, anyone rooting for VBTLX to beat the CD over five years should have been hoping for interest rates to continue rising in 2014.
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Old 05-28-2015, 08:59 AM   #11
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I think this kind of analysis is very valuable and frequently do it myself to evaluate the investment decisions I've made. After all, if I'm never willing to critique my own decisions, I'll never be able to learn from experience and avoid repeating a mistake.
It's very difficult to determine if an analytical "mistake" has occurred. If the original decision was based on the best information available and the best analysis of the information, and it still turned out badly, that does not indicate that a mistake was made. Any investor's record--be it 6 months, 15 months, or 100 years, provides just a tiny sliver of data. Studies done with much more data, and much more rigorous controls for variables, still produce inconclusive results. So, I don't think retrospective analysis of our results will help us develop better analytical models.
But I do think it can point out our behavioral/psychological/perceptual shortcomings, and that can be really useful. E.g.: If I had a plan to strictly rebalance to a fixed AA (and this was based on solid research), but I got influenced by the "financial porn" and varied from my plan, it's useful to retrospectively see what influenced me and if that was a rational decision. Whether it turned out to be right or wrong (based on results) is largely irrelevant--sample size too small.
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Old 05-28-2015, 09:57 AM   #12
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It's very difficult to determine if an analytical "mistake" has occurred. If the original decision was based on the best information available and the best analysis of the information, and it still turned out badly, that does not indicate that a mistake was made.
That's true, so let me explicitly state what I was trying to subtly infer earlier - it would be an outright mistake to conclude that a total bond fund is currently a better investment than a CD with a 3% yield and having 45 months remaining until maturity, in spite of the fact that the total bond fund is ahead of the CD right now. In this case, not only do past results not predict future returns, but are downright harmful to future returns in a clearly measurable way.

Does this mean that there's no possible way for the total bond fund to outperform the CD over the entire five year term? Of course not. But the fact that the CD interest is compounding at 3% while the bond dividends are compounding at only 2% gives the CD a built in advantage over the bond fund that more than outweighs the small advantage the bond fund has accrued in the first 15 months.
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Old 05-28-2015, 10:19 AM   #13
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kiki......


I agree. I looked at transferring IRA money to PenFed or another institution which frequently offers (relative) high yield CD's. This appeared to be a bit of a hassle due to opening/closing IRA's, entries on my tax form, etc. And since there are times when I trade in my IRA or sometimes hold an equity heavy AA, I'd probably be moving some or all of the funds back to the brokerage sometime in the future. I didn't want to do that if the rewards weren't going to be worthwhile. So, I didn't make the move and like you I have been satisfied with holding bond funds (so far).


There are situations where CD's are the most appropriate. But for me, IRA money, where the plan is to hold the IRA until RMD's begin and also to shift investments with some frequency over time, isn't often one of them. If I could find a brokerage house offering CD's at PenFed or similar rates so the transferring back and forth wasn't necessary, that would also make it a different story.


Edit: I'll add that I have a fairly large CD in DW's rollover IRA. It's a brokered CD paying 5% I bought a number of years ago at Schwab. (It matures this autumn.) But Schwab seldom has CD's that compete with PenFed rates so most likely moving IRA money (opening new IRA's) at a PenFed type institution would be necessary if having CD's in her IRA were a long term part of our strategy.
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Old 05-28-2015, 10:38 AM   #14
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Nevertheless, I find it far from clear that the small lead that VBTLX currently holds over the CD will hold up over the entire five year term. I gather that the CD has a 3% yield compounded quarterly for 20 quarters. At the end of the five years it should be worth $34,835.52. What VBTLX will be worth then is, of course, unknown, but I see that the total bond fund currently has an SEC yield of only 2%. Taking the 31,394.97 value on 5/18 and compounding a 2% monthly yield for the remaining 45 months of the five year term, I estimate that VBTLX will only grow to about $33,838 by the time the CD matures, even if the bond fund doesn't suffer any decline in NAV. So, my money would be on the CD beating the bond fund by about $1,000 over the entire five years, with the big unknown being how fluctuations in NAV will change the final value of the hypothetical investment in VBTLX.

The underlying problem with extrapolating 15 months of returns to a full five years is that a lot of VBTLX's current advantage is based on increases in NAV from 2/2014 through 1/2015. Bonds were rallying strongly for this entire 12 month period. But (somewhat perversely) the big bond rally was bound to hurt future returns because dividends were getting reinvested at higher and higher prices (resulting in lower and lower yields). Ironically, anyone rooting for VBTLX to beat the CD over five years should have been hoping for interest rates to continue rising in 2014.
I'm not trying to extrapolate a full five years based on 15 months of data. I expect that both will be close and still give advantage to the CDs, much like I did 15 months ago. What I found interesting is that there was a big bond rally - much against common thought 15 months ago - that led us to this point. It will be interesting to see how this evolves over the next 45 months.

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But I do think it can point out our behavioral/psychological/perceptual shortcomings, and that can be really useful. E.g.: If I had a plan to strictly rebalance to a fixed AA (and this was based on solid research), but I got influenced by the "financial porn" and varied from my plan, it's useful to retrospectively see what influenced me and if that was a rational decision. Whether it turned out to be right or wrong (based on results) is largely irrelevant--sample size too small.
Sam, I think you bring up an important point regarding behavioral aspects to investing. I pretty much stick to my AA, but I'm not against making changes when it makes sense for my situation. This case is a good example. Fifteen months ago I compared CDs vs a Total Bond Fund. For me, the FI part of my portfolio should be safe. At the time (and even now), the Total Bond Fund looked riskier than the CDs. So I took a percentage of my FI allocation and bought CDs. I still own the Total Bond Fund, in a higher percentage than CDs, but the CDs provided a way for me to lock in a guaranteed 3%.

It's also important to focus on your total AA and not a single investment. This is why I didn't move everything into CDs. That would have prevented me from being able to rebalance at the end of the year, etc. This way I ended up with flexibility to rebalance between FI and equities and lock in a guaranteed return.

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That's true, so let me explicitly state what I was trying to subtly infer earlier - it would be an outright mistake to conclude that a total bond fund is currently a better investment than a CD with a 3% yield and having 45 months remaining until maturity, in spite of the fact that the total bond fund is ahead of the CD right now. In this case, not only do past results not predict future returns, but are downright harmful to future returns in a clearly measurable way.

Does this mean that there's no possible way for the total bond fund to outperform the CD over the entire five year term? Of course not. But the fact that the CD interest is compounding at 3% while the bond dividends are compounding at only 2% gives the CD a built in advantage over the bond fund that more than outweighs the small advantage the bond fund has accrued in the first 15 months.
So true. Nobody knows the future. The only reason I originally posted this analysis is because of the other thread, "when to get back in bond funds." In the end, if bond funds are part of your AA, then you should be in bond funds. You don't know what they will do over the next 45 months or any time frame. Plus, PenFed isn't offering 3% CDs at the moment.
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Old 05-28-2015, 01:37 PM   #15
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The favorable performance of the bond fund vs the CDs is due to the increase in the NAV due to falling interest rates. When they rise, the NAV will decline below your buy-in price, leaving just the interest payments from the bonds in the fund for your gain. If you never plan to "touch principal", ie never sell the shares in the fund but just spend the interest, then the CDs may be better.


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Old 02-10-2016, 10:46 PM   #16
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It's time for an update. I decided to update the thread every year after the purchase date. The CD I purchased was on 1/31/2014 for $30k. The original date I posted wasn't correct. This is year #2 in a 5 year CD.

As of 1/31/2016 the CD is worth $31,857. If the money was invested in VBTLX it'd be worth $31,858.

Not much of a difference at this point.

As an interesting side note, I noticed that the NAV for VBTLX is at 10.85 today, much higher than the 10.77 NAV at the end of January. At that price, it'd be worth $32,095 and the CD $31,883. Just goes to show that the value of VBTLX can fluctuate quite a bit.
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Old 02-11-2016, 09:13 AM   #17
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In terms of performance it's pretty simple. If yields decline over the 5 year period the bond fund wins. If yields increase over the 5 year period the CD wins. If yields stay the same, it's a wash.

Seen this way, the choice between CDs and a bond fund is mostly a market timing decision. Or, if you prefer, a risk management decision. I choose the later explanation.

When rates are very low, as now, there's more risk in owning duration (e.g. bond funds) than potential rewards. That favors owning CDs from a risk / return perspective.

Also, credit risk is higher in the Bond Fund. So comparing CDs which are essentially US Treasury risk with a Bond Fund that holds 34% of its portfolio in non-treasury securities is a bit of an apples to oranges comparison. To get a sense of how much this credit risk is worth, consider that Vanguard's intermediate treasury fund yields a full 1% less than the bond fund even though it has a slightly shorter duration.

Finally, CDs come with a low cost interest rate put option. If interest rates soar, I can break the CD and reinvest at market rates. That's hugely valuable, even though the option has consistently been out of the money.

All else being equal, I'd expect to get paid much more to hold a bond fund that exposes me to more interest rate risk and credit risk than than a CD that has very little exposure to either. I'd also expect to pay a premium for the interest rate put option embedded in the CD.

In short, CDs should yield far less than the bond fund

As things stand today, the bond fund yields 2.3% which is nearly identical to the 2.25% current available from certain online CDs. That doesn't seem like appropriate compensation to me.
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Old 02-11-2016, 10:34 PM   #18
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Gone4Good, the reason I do this analysis is because I want to know if it was worth the hassle of creating an IRA at PenFed and transferring funds to Vanguard. That's not hard, but it's still extra work and I like to keep things simple. I realize that the CD is a sure thing at 3% and that the bond fund has more risk exposure, but if the net value at the end of 5 years for both vehicles is about the same, I'd opt to go the simpler route (for me) and own the bond fund.

Keep in mind that at the time the thinking about bond funds was very negative. Based on two years of data, the bond fund has held up fairly well, even with a recent rate increase. I suspect future rate increases will also be small and spread out, so I doubt it'll be much worse going forward.

Another negative for me is that I don't keep much in FI (15-20% of portfolio) and having a big chunk of it locked up in CDs has limited my ability to rebalance on market swings, especially for tax loss harvesting.

I still think that the CD will probably come out a bit better than the bond fund, but based on two years of results, I don't think it'll be much of a difference. In my case, I probably should have stayed with the bond fund, but in tracking performance over time I'm learning something new, so it's all good.
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Old 02-12-2016, 09:12 AM   #19
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Gone4Good, the reason I do this analysis . . .
Sorry if I gave the impression I was challenging you in any way. Mostly I was just laying out my thoughts on CDs vs. The Bond Market Fund.

And yeah, it's true that most of us wouldn't have suspected that bonds would continue to outperform year after year even from very low starting yields. That's why market timing is hard. Your thread reminds us of that.

So we agree, it's all good.
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Old 02-12-2016, 10:39 AM   #20
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Sorry if I gave the impression I was challenging you in any way. Mostly I was just laying out my thoughts on CDs vs. The Bond Market Fund.
No worries. Based on your response I wasn't sure if you knew where I was coming from. I spend a lot of time analyzing my investment approach and this is just one example. I find it helpful to occasionally break from the theoretical and look at hard numbers. I find this case especially peculiar since based solely on yields, the CD should be outperforming.

I appreciate your CD vs TBM analysis and I'm in agreement, but I'm coming to the conclusion that in many cases, it probably doesn't matter that much. After 10 years of investing I'm realizing that simple is better and my numbers back this up. Honestly, it's a little frustrating, since you'd think a little tinkering here and there would help, but it looks to be marginal at best. Maybe I tinker too much?
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