Bond's vs CD's

[Roger_R]

Pardon my lack of expertise.  I am not totally new to the investment world, but am quite new to the exploration of fixed income.  I have especially enjoyed reading the essays by Robert B. Gordon and his strategy for building a stable growth portfolio.  In at least of few of his articles, he lists US Treasury bonds as major asset class to include in a portfolio.  If you would compare the returns on savings bond rates, a 5 year bond would return about 2.6%.  Alternately you could purchase a 5 year CD (FDIC insured) through someone like ING that would return 4%.  Using the risk vs return philosophy, I can't see any additional risk or other disadvantages of any significance that would relate to the CD investment, as it is insured by the same entity issuing the lower interest bonds.   Am I missing something?  

 

[wabmester]

There is slightly more risk with a CD in that only the original principal is insured and not the interest. And, of course, there are insurance limits. There is also a liquidity premium (or rather an illiquidity premium) on CDs.

Of course, if these minor risks don't bother you, then CD's are the way to go.

 

[Peter]

I have the impression that, right now, there's a larger-than-usual difference between treasury issues and other instruments of similar maturity.

For example, a 3 month note is earning well under 1%, while there are several money market accounts available in the 2% to 2.5% range (e.g. ING, GE, Ford).

Surely such a big difference can't be entirely due to higher risk?

Peter

 

[brewer12345]

Seems to me that CDs are a no brainer right now. A few weeks ago, I bought an ING 5 year CD yielding 4.25%. 10 year treasuries are only yielding 4%. I have no idea why there is such a spread, but there is no way that CDs justify a risk premium of ~250 Bp over treasuries.

 

[fire5soon]

Perhaps the bank issuing the CD anticipates a rise in rates and is trying to entice investors with rates slightly higher than current market, only to lock them in to take advantage when rates rise.

I hope that made sense. Just a thought...

 

[wzd]

Another tradeoff to think about - While bonds are more liquid, CD's may actually be safer. My reasoning here is that if rates go up, the price of the bond will drop substantially. To liquidate a bond, you sell at the market price.

For the same case with a CD, you can liquidate it with a fixed penalty of usually 6 months interest.

I think CD's make a lot of sense in todays market, since the rate is higher, and the market risk is limited (Of course that doesn't hold for brokerage CD's). If no one else beats me to it, I may look at the math for the trade-off point in a rising interest rate environment, but at the moment, it's time for me to go play volleyball.

Wayne

 

[AltaRed]

I fully agree with wzd. Bonds are a significant capital loss risk now because current interest rates have nowhere to go but up. On that basis, any bond purchased today has risk of capital loss if sold prior to maturity.

I would only consider a standard Treasury bond today if I felt I might need to access the money before maturity and I would have to measure that risk against the interest penalty that would be incurred if an alternative purchase of a CD was liquidated. It is pretty hard to beat ING these days and I personally have a bunch of cash with ING for this very reason.

 

[wzd]

Just some info I looked up:

ING 5 yr: 4%APY
early withdrawal penalty = effectively 1/2 of the total interest earned. I'm not sure what the weasel word effectively means in this context.

Penfed 5yr: 5.25 APY
early withdrawal penalty = 180 days interest

If I use the 5yr penfed rate, and look at cashing in after 1,2,3,4 years:

1 year, 2.628%
2 year, 4.008 average annual rate
3 year, 4.563 average annual rate
4 year, 4.915 average annual rate

Unless I am missing something, the rates still look good after the penalty! Not much of a liquidity premium here.

Wayne

 

[Roger_R]

Again, I am still learning, and have to beg forgiveness to ask, what is "penfed".

 

[wabmester]

one size fits all CD ladder

Yeah, that is an interesting side effect of their penalty algorithm. Not only are their CDs better than treasuries, but they've structured it such that there's no reason to buy any term other than 5-year. All of their shorter terms yield less than a 5-year CD less early withdraw penalty for a given term.

 

[ganda]

Penfed 5yr:  5.25 APY
               early withdrawal penalty = 180 days interest

If I use the 5yr penfed rate, and look at cashing in after 1,2,3,4 years:

1 year, 2.628%
2 year, 4.008 average annual rate
3 year, 4.563 average annual rate
4 year, 4.915 average annual rate

This is exactly what we've done with the cash we intend to buy a house with in about 22 months. I couldn't find a better, secure return. And if it takes us 25 months to find the house, then the money can sit there earning