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five year CD or a three year CD?
Old 11-07-2008, 12:46 PM   #1
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five year CD or a three year CD?

A local credit union is offering a five year CD at 6 percent is this a good deal and would you do it? Or would you take a 3 year CD at 5 percent? Which is the better deal?
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Old 11-07-2008, 12:53 PM   #2
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I'd do the 6% for 5. But I would guess it depends on how the rest of your portfolio is set up.
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Old 11-07-2008, 01:06 PM   #3
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What are the early withdrawal penalties on these two CDs?
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Old 11-07-2008, 01:11 PM   #4
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I think three months instrest.
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Old 11-07-2008, 01:37 PM   #5
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I think three months instrest.
That seems awfully low, which is attractive. In that case I would go for the higher rate, since if your plans change you would not get hit with much of a penalty.
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Old 11-07-2008, 04:48 PM   #6
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5 Years at 6% - but then I always buy CD's at the longest term with the best interest rate - but I have built a CD ladder for 30 years. I have never got burned by doing it. I have never redeemed a CD early however usually the longer the term the larger the penalty. I would be very surprised if the 5 year one does not carry a 1 year penalty. Depending on the compounding factor (daily/monthly/annually) and the APY versus the APR - APY is important only if you do not intend to withdraw the interest earnings monthly; if you withdraw earnings every month the APY does not matter - APR does. BTW where is the rate available as the best I can find is 5.5% APY - 5.25 APR at Capital One Bank.
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Old 11-07-2008, 10:05 PM   #7
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I'd be concerned with inflation over a 5yr period. Bill Gross has mentioned staying short because of inflation concerns which are, of course, only visible in retrospect. Right now the present concern is disinflation but only a few months ago it was inflation (remember the high oil prices?). Personally for 5yrs I'd buy TIPS.
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Old 11-08-2008, 04:52 AM   #8
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I'd be concerned with inflation over a 5yr period. Bill Gross has mentioned staying short because of inflation concerns which are, of course, only visible in retrospect. Right now the present concern is disinflation but only a few months ago it was inflation (remember the high oil prices?). Personally for 5yrs I'd buy TIPS.
Would not the CD's be better than TIPS if, like you say, we are in a (possibly long-term) deflationary (disinflation) period. TIPS are governed by the official CPI rate of inflation, which has been 3.4% over the past 5 years, (and TIPS would, I think, be impacted by deflation, i.e., could actually have negative growth). The CD, at 5%, would have provided an assumed 1.6% of real growth over the past 5 years.
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Old 11-08-2008, 08:44 AM   #9
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Would not the CD's be better than TIPS if, like you say, we are in a (possibly long-term) deflationary (disinflation) period. TIPS are governed by the official CPI rate of inflation, which has been 3.4% over the past 5 years, (and TIPS would, I think, be impacted by deflation, i.e., could actually have negative growth). The CD, at 5%, would have provided an assumed 1.6% of real growth over the past 5 years.
The "real return" on the TIPS will be same no matter if there inflation or deflation.
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Old 11-08-2008, 09:19 AM   #10
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I know what happens to the CD if future CPI is negative (deflation) it just pays the initial rate to maturity, while the TIPS pays initial base rate (currently about 0) plus the CPI based inflation rate (averaging 3.4% over the the past 5 years). I realize that the past rate has nothing to do with future CPI rates but, if it is deflationary, (assuming this for the sake of argument) the TIPS would pay 0, would it not (at least considerably less than the CD rate which is LOCKED to maturity)? I have owned TIPS in the past (and have nothing against them at all, just trying to answer OP's question) but if I can get 6% FDIC (I can get 5.5% today) for the next 7 to 10 years why would I buy tips? Can you receive TIPS interest monthly like you can on some CD's?
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Old 11-08-2008, 09:57 AM   #11
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As mentioned TIPS will do OK in deflation (1yr of negative CPI rates). The inflation factor on the TIPS will go down but the dollars you hold in them will be worth more. CD's would then do better. When is the last time we had an extended period of deflation? Do you seriously think we will have extended deflation over years?

You might do better with CD's if we don't have unexpected inflation. Personally I'm assuming disinflation (lower inflation, not deflation) over the next 1-2 years. Further out who knows but that unexpected inflation insurance is worth something to debt holders. In the US the bias is towards growth and stimulous and not to rewarding debt holders with ever more stronger debt. With deflation your dollars get stronger and your debt holdings (bonds, CD's) get stronger. You have only to look at the recent elections to see where things are going. Both Gross and Buffet have said the likely path is towards higher inflation in the future -- and they weren't talking about the next few months.

TIPS provide safety, are at historically attractive rates, and have that inflation insurance I keep harping on . You buy the insurance when it's cheap. Things can change very quickly as we've seen in 2008 with the inflation fears in the early months and lousy TIPS (real) rates then.

So that is my take and it's not completely original but it reflects my bets. Unfortunately we all do have to place those bets one way or the other.
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Old 11-08-2008, 11:17 AM   #12
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Consider this. This is a world-wide recession. It is anticipated that our balance of payments (what we export vs what we import, typically more in that out ) will drop significantly this quarter. Let us now assume that the recession deepens which is not a bad bet. Calls for government spending will ring through the halls of congress to get the economy moving again. Since we have operated the federal government by borrowing money for the last eight years, meaning we spend more than we take in in taxes, this trend will most likely continue, maybe accelerate. A lot of this borrowing comes from foreign sales of T-bills paid for from excess $ from the trade imbalance. Smaller trade imbalance = fewer dollars for China et al. to purchase T-bills. What to do?

They could, 1) raise taxes on everyone. Not a good way to stimulate the economy. Or they could 2) somehow make T-bills more attractive by (can we get a drum roll please) raising interest rates. CD's would follow suit. All this would certainly increase the value of the dollar also which would result in fewer exports, increasing the trade imbalance again.

I can see why PIMCO would advise that bond investors maintain a short position until all this shakes out. In August I got my bank, through some back office negotiations, to agree to a rate (I think it was around 4.5% apr) with a one-time interest rate reset during the term with no penalty. We'll see how that works out in the end. It was interesting to see how negotiable that whole process really is though.
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Old 11-08-2008, 11:48 AM   #13
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I know what happens to the CD if future CPI is negative (deflation) it just pays the initial rate to maturity, while the TIPS pays initial base rate (currently about 0) plus the CPI based inflation rate (averaging 3.4% over the the past 5 years). I realize that the past rate has nothing to do with future CPI rates but, if it is deflationary, (assuming this for the sake of argument) the TIPS would pay 0, would it not (at least considerably less than the CD rate which is LOCKED to maturity)?
Yes, your nominal rate of return on the TIPS could be zero, but your real rate of return will be the same no matter what happens to the CPI-U.

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I have owned TIPS in the past (and have nothing against them at all, just trying to answer OP's question) but if I can get 6% FDIC (I can get 5.5% today) for the next 7 to 10 years why would I buy tips?
Because you want inflation protection. With nominal fixed income [like CDs] you're betting that there will be low inflation or deflation. With TIPS, you're hedging. If the CPI-U goes up, my expenses will likely go up. And if the CPI-U goes down, my expenses will likely go down. Of course, as CFB has pointed out numerous times, your personal rate of inflation is different, and sometimes much different than the CPI-U.

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Can you receive TIPS interest monthly like you can on some CD's?
Nope. The individual bonds pay their coupons every six months, and the mutual funds [at least Vanguard's] pays distributions quarterly.

Edited to add:

Also, ind TIPS don't pay out the inflation adjustment until the TIPS matures, so you only get the coupon until the bond matures.

I must say though, getting 6% CD for 5 years seems like a pretty sweet deal.

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Old 11-08-2008, 12:58 PM   #14
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if the CPI-U goes down, my expenses will likely go down.
Wouldn't your expenses just grow at a slower rate? That is, the rate of growth of your expenses would go down but your expenses would still be rising unless we went to zero inflation or to deflation.
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Old 11-08-2008, 01:04 PM   #15
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...
I must say though, getting 6% CD for 5 years seems like a pretty sweet deal.
As a comparison, the 1/15/2014 (about 5.2 yrs out) TIPS is at 3.54%. Not too shabby either ... and there is that inflation protection component.
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