Bond Fund vs CD In the Next Five Years

[modhatter]

Treasury bonds - 5 Yr - 1.773%

A 3% cd beats that nicely.

With some end of the year rebalancing, I'm moving about 5% of my investments to penfed.

I'm curious if this is an end of the year special and if it will change or not in the new year.

I was told by PenFed representative that the CD was for the month of December, so I imagine come Jan 1st., it will be gone. PenFed usually has a better than most offer in either Dec or Jan each year.

 

[pb4uski]

CDs do have interest rate risk. It's called "opportunity cost". E.g. I buy a 5yrCD yielding 2%. Tomorrow the same CD pays 2.5%. My CD just lost 2.5% in value compared to the new CD even though the face value of both remains the same.

CDs do not have interest rate risk because a change in interest rates does not change the cash out amount of the CD because the early withdrawal penalty is fixed by contract.

Let's say your 5 year CD has a 1 year of interest early withdrawal penalty and you are one year into the contract. You can cash it in for 100 (102 - 2 withdrawal penalty). The next day interest rates go up 1%. You can still cash it in for 100. Therefore, the CD does not have interest rate risk because interest rates don't affect the value of the CD.

Note, I'm speaking of bank CDs. If brokered CDs, I would agree that they have interest rate risk.

The new 2.5% CD is just better/more valuable than the existing 2% CD.

The 2% CD hasn't "lost" value, it is just something better has come along.

BTW, if it did happen "tomorrow" you would probably be in the grace period and could swap put for the 2.5% CD so it would be no big deal.

 

[haha]

From a pretty good short piece by Samuel Lee at Morningstar:


"Bonds, on the other hand, are very predictable. Over the next three to five years, your returns are going to be close to the starting yield. In Exhibit 2, I plot the forward three-year nominal annualized returns of the Ibbotson Associates SBBI Intermediate Government Bond Index versus its starting yield, using data from 1926 to 2013. The resulting plot is about as clean as you're going to get: Returns move one-for-one with yield in high-quality bonds. One would have to be daft not to take into account valuation when deciding one's bond allocation.

Excellent article, thanks for posting. I also believe to ignore valuations (or in bonds yields as a proxy for valuations) is playing your hand with your eyes closed. With bonds, though, the question is not are these yields high or low, but what I can expect in yields available for the duration of these bonds. To me, this I shard, especially now. I do not think it is an o-brainer that yields will go meaningfully higher anytime soon. Maybe will, maybe won't. Look at Japan.

Ha

 

[F4mandolin]

I just sold the last of my bonds....even though it throws the AA waaaay out of whack. I would rather adjust with the G fund in TSP. But I think I am taking a bit of risk over the next year and just leaving the AA out of whack towards stocks. If the market goes up......we have enough to go back to the UK. If the market goes down....we stay where we are..which isn't so bad at all. Pssst....we aren't talking millions....maybe $60-70K.

 

[obgyn65]

I agree with this, but I still prefer CDs to bond funds.

CDs do have interest rate risk. It's called "opportunity cost". E.g. I buy a 5yrCD yielding 2%. Tomorrow the same CD pays 2.5%. My CD just lost 2.5% in value compared to the new CD even though the face value of both remains the same.

 

[clifp]

Great article.

I loved this story.

Yes, Virginia, you can time the market--if you have the brains and the courage to do so. I wouldn't be surprised if lots of experts preaching buy and hold are closet market-timers. Academics can be notorious hypocrites. In a 1994 speech at the USC Marshall School of Business, Charlie Munger said, " … one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy." [2] According to Fortune magazine, that economist was Nobel Prize winner Paul Samuelson, whose work on efficient markets inspired Jack Bogle to launch the first Vanguard index fund.

Which I guess goes to show that some Nobel Prize are pretty good investors and can spot talent. (Berkshire stocks was 16,000-20,000 during 1994 is up roughly 10x over the last 19 years $176,000)

 

[NW-Bound]

Do as you are told, not as I do. Heh heh heh...

Well, the market efficiency theorists try to protect the dumb public from hurting itself, but they themselves are smart enough to make the right decisions to benefit from the folly of the mass. Heh heh heh...

 

[jetpack]

CDs do have interest rate risk. It's called "opportunity cost". E.g. I buy a 5yrCD yielding 2%. Tomorrow the same CD pays 2.5%. My CD just lost 2.5% in value compared to the new CD even though the face value of both remains the same.

If you buy a 5 yr 2% cd today, you already lost 1% because the penfed CD is paying 3% today. That is opportunity loss.