I am a secondary market brokered CD convert

[Earl E Retyre]

The more I learn about secondary market brokered CDs, the more I like them.

Like many, I believe interest rates will be lowered over the course of this year and so I have been locking in longer term CDs (e.g., 5-7 years) to as close to a 5% return as I can get. While I was able to purchase 5% new non-callable 5 year brokered CDs a little while ago, lately, when I look at new brokered CDs, I see the best long term rate I can get is only around 4.1% for a non-callable.

When I look at secondary brokered CDs, I have recently been purchasing CDs around a 4.7% Yield To Worst (YTW). I have been researching what YTW really means and learned that YTW is the rate you get if the CD never gets called (i.e., equivalent to the Yield to Maturity) - ASSUMING you are buying the CD with a coupon lower than the going rate (below par) which I almost always do. While 4.7% is the worst I can earn, if the CD gets called, I earn even more (and potentially a lot more).

So, here are 2 examples.

Yesterday, I purchased a LIVE OAK BANK CD at a YTW of 4.7% (coupon of 3.65%) that matures on May, 2032 (8 years). Assuming the CD never gets called then it will pay me the equivalent of 4.7% over the life of the CD. From a cash flow perspective, it pays me the equivalent of a 3.9% CD annually (since I purchased below par) but at the end when the CD matures and I get my principal payment, it will be the equivalent of a 4.7% annual CD. The main thing I recently learned was how to compute the Yield To Call (YTC) if the CD gets called prior to maturity. In this example, it would be as follows: if called after 1 year it would be 11.58% return, after 2 years it would be 7.62%, after 3 years it would be 6.33% and so on down to 8 years at 4.7%. So, while I prefer the CD doesn’t get called, if it does, I make out like a bandit. I think a coupon of 3.65% has a slight chance of getting called if rates decline rapidly, but in this case, I am happy either way.

As a second example using a shorter term CD and lower coupon, I recently purchased a JP MORGAN CD with a YTW of 4.64% (and a coupon of 3.05%) that matures on May 2027 (3 years). If the CD never gets called (which it most likely will not at such a low 3.05% coupon) then it pays the equivalent of 4.64% at the end of the 3 years. If it gets called after one year then it pays 15.56% and 2 years 9.25%. So again, in the off chance it gets called, then I get a really good rate.

I am pretty sure I am doing my calculations correctly since I read a couple blogs and created my own spreadsheet. Then I found an online calculator and plugged in the same CD values and it returned the same YTC, YTM, YTW numbers as my spreadsheet. But anyone please let me know if you think I am making any errors. Assuming I am correct, then I am really liking these brokered CDs on the secondary market and am just hoping the Fed does not lower rates over the next couple months since I have some more older, traditional CDs maturing. I used to look for a coupon in the low 3's to try and ensure they do not get called. But now I am thinking a rate in the upper 3's is ideal since it gives a greater cash flow, will still likely not get called, and if it does get called then I make an even greater return than going out to maturity.

 

[Golden sunsets]

The math certainly makes sense. What brokerage firm are you using to purchase these secondary market CD's?

 

[audreyh1]

Wow, nice finds!

Some folks must be desperate to dump these things.

 

[Earl E Retyre]

The math certainly makes sense. What brokerage firm are you using to purchase these secondary market CD's?

I use both Fidelity and Vanguard. Often times, but not always, the same CDs appear on both sites.

I find it interesting how many CDs come and go throughout each day. Fidelity did allow me to set up a search so that I can hit one button and quickly see availability meeting my criteria of maturity date, YTW and coupon.

 

[Earl E Retyre]

Wow, nice finds!

Some folks must be desperate to dump these things.

I am surprised how easy it is to find these. On the weekends, they are gone, but if you search during the week, there seems to be plenty of good ones.

 

[audreyh1]

So when the CD matures and you get paid back a lot more than your initial cost basis, is that a long term capital gain?

 

[Earl E Retyre]

So when the CD matures and you get paid back a lot more than your initial cost basis, is that a long term capital gain?

So far I have been primarily purchasing these in my IRA/tax advantaged accounts so that does not apply to me. I am going to start buying some in my taxable account next month ... and then it will apply.

I do believe that it would be a capital gain ... however, it is not a lot more. In the example above, I purchased a $20k CD for $18,578 so I believe that would be a LT gain of $1,422. I am thinking though that a LT gain would be more tax advantageous than paying income tax on interest anyways.

 

[audreyh1]

Some of that initial price was paying accrued interest, right? So it seems the cost basis might be a bit lower. And you get to subtract the pre-paid interest from your first coupon payment.

Yes, no doubt long term capital gain is better that interest tax wise.

 

[Golden sunsets]

If you don't mind sharing, are the amounts that you are able to buy in amounts that make it worth it? I have seen some juicy rates on brokered Fidelity CD's but only in very limited quantities.

My search criteria are similar to yours; Looking for replacements of maturing CD's in the 5% range that mature in 5 years. But I am also looking for buys in the $50,000 range. We have a CD maturing in April that I'm looking for a replacement for. I'd buy it now, before the CD matures, if I could find the rate. I'm currently seeing the rates much higher at individual institutions. I'd prefer to simplify and keep the money at one brokerage, rather than chasing obscure banks for each of my 5 year ladder, but if rates are nearly 1% higher at banks, I have to decide if I should sacrifice some yield for the convenience.

 

[Earl E Retyre]

If you don't mind sharing, are the amounts that you are able to buy in amounts that make it worth it? I have seen some juicy rates on brokered Fidelity CD's but only in very limited quantities.

My search criteria are similar to yours; Looking for replacements of maturing CD's in the 5% range that mature in 5 years. But I am also looking for buys in the $50,000 range. We have a CD maturing in April that I'm looking for a replacement for. I'd buy it now, before the CD matures, if I could find the rate. I'm currently seeing the rates much higher at individual institutions. I'd prefer to simplify and keep the money at one brokerage, rather than chasing obscure banks for each of my 5 year ladder, but if rates are nearly 1% higher at banks, I have to decide if I should sacrifice some yield for the convenience.

I don't mind sharing. In the Live Oak Bank example above, there were something like $400k available. I actually initially bought $20k ... went for a hike and then decided it is such a good deal that I should buy some more and bought another $40k for a total of $60,000. In the JPM example above, I bought $50k. Having said that, I did buy one at a 4.85% rate that only had $5k available. I was debating whether it was worth it for so little but decided, why not? It is a good rate and just means one more entry in my spreadsheet. I generally try to buy at least $20k but for the right deal I will buy less.

I just did a quick search on Fidelity and even though it is the weekend there are a couple that are not too bad. For example, CUSIP 15118RYV3 has $29,000 available at a YTW of 4.52 and a coupon of 3.7% and a maturity of 6/15/32.

 

[Earl E Retyre]

Some of that initial price was paying accrued interest, right? So it seems the cost basis might be a bit lower. And you get to subtract the pre-paid interest from your first coupon payment.

Yes, no doubt long term capital gain is better that interest tax wise.

It it did have $20 of accrued interest. The $18,578 is the cost basis that it is showing.

 

[audreyh1]

Do you know if that prepaid interest is treated as art of the cost basis or separately?

 

[Earl E Retyre]

Do you know if that prepaid interest is treated as art of the cost basis or separately?

It is treated as part of the cost basis ... I just looked at my purchase for the JP Morgan CD ... I paid a total of $47,984.25 which had an accrued interest of $334.25. When I look at what Fidelity says I have for a cost basis, it is telling me $47,650. So, it is subtracting the accrued interest for my cost basis.

 

[audreyh1]

OK - just curious. Thanks much for answering all my questions.

 

[Golden sunsets]

I'm a little confused on the accrued interest issue. It's my understanding and experience with Fidelity that they report accrued interest as a separate line item on their 1099. They report it in the year that the purchase is made, which raises another issue if your next interest payment on the issue occurs in a subsequent year. My CPA adjusted for that in the return, which makes it a bit of an exercise.

Am I missing something?

 

[Earl E Retyre]

I'm a little confused on the accrued interest issue. It's my understanding and experience with Fidelity that they report accrued interest as a separate line item on their 1099. They report it in the year that the purchase is made, which raises another issue if your next interest payment on the issue occurs in a subsequent year. My CPA adjusted for that in the return, which makes it a bit of an exercise.

Am I missing something?

This is the first time I am buying secondary market brokered CDs so I am glad you are bringing this up. I also do my own taxes and don't hire a CPA.

So ... if I understand what you are saying, Fidelity will report accrued interest as a separate line item. I assume Vanguard would do so as well. That line item should trigger me to know to subtract the accrued interest from my interest income so I am not paying extra taxes on the accrued interest. Or perhaps the tax software does it for me.

 

[Big Gun]

Accrued Interest

If the accrued interest on a secondary market brokered CD is treated the same as accrued interest on a secondary market treasury, then it should be pretty straightforward in whichever tax software you use.

I saved a discussion string over at bogleheads that has a step-by-step on how to do this in TT, which is what I use, and intend to use it on my 2023 return - I had purchased the secondary treasuries in calendar year 2022 but hadn’t received interest until calendar year 2023, and you cannot deduct the accrued interest unless you have earned/received interest. So I had to wait until filing my CY2023 return to deduct the accrued interest, even though I ‘paid’ the accrued interest in 2022. Clear as mud?

 

[audreyh1]

If the accrued interest on a secondary market brokered CD is treated the same as accrued interest on a secondary market treasury, then it should be pretty straightforward in whichever tax software you use.

I saved a discussion string over at bogleheads that has a step-by-step on how to do this in TT, which is what I use, and intend to use it on my 2023 return - I had purchased the secondary treasuries in calendar year 2022 but hadn’t received interest until calendar year 2023, and you cannot deduct the accrued interest unless you have earned/received interest. So I had to wait until filing my CY2023 return to deduct the accrued interest, even though I ‘paid’ the accrued interest in 2022. Clear as mud?

Well I suppose it’s simply because you get to subtract it from the next coupon payment, thus reducing your taxable income from that particular interest payment. If that’s not until the following year, you have to wait.

 

[pb4uski]

Yes. When you pay accrued interest you are paying the seller for a portion of the next coupon that you will later receive as the buyer... so if it is a semiannual coupon and the next coupon is $600 and the last coupon as paid 4 months ago then the accrued interest will be $400... the net of the $600 coupon that you receive and the $400 of accrued interest paid is $200 and is interest to you for the 2 months that you have owned the bond.

 

[Golden sunsets]

Well I suppose it’s simply because you get to subtract it from the next coupon payment, thus reducing your taxable income from that particular interest payment. If that’s not until the following year, you have to wait.

Yes, I created a spreadsheet showing the accrued interest reported by Fido on the 2022 1099 return and whether it applied to 2022 or 2023. My accountant used this spreadsheet to correctly apply the accrued interest. A large portion of the accrued interest actually applied to 2023 earnings and so will be handled on the 2023 return. It seemed to me that this extra work was not ideal. It wasn't a problem for me, but some folks would not think to generate this sort of an anslysis.

 

[audreyh1]

I haven’t dealt with paying accrued interest in a taxable account, just tax deferred. It’s interesting.

I have bought some TIPS at auction and there you always pay some accrued interest because of the delay between the auction and settlement date which is usually not aligned with the next coupon date either. You get the next full coupon. Also you pay some small inflation adjustment which becomes part of the basis.

 

[Earl E Retyre]

Thanks everyone for your replies .... now I understand how the accrued interest works and how it will affect my taxes. This was very helpful.

 

[Earl E Retyre]

Wow ... I just looked and I purchased 1 secondary market CD in my taxable account in 2023. The rest are all in my tax advantaged account. I just went into my tax software and checked the box saying I had accrued interest and entered the amount from my Vanguard 1099INT. I would have completely missed this had Audrey not asked questions about accrued interest which triggered Golden sunsets to explain what he does on taxes. So ... thanks again peeps. It was not a huge dollar savings for 2023 but since I will likely buy more in my taxable account in 2024, I will know to do this moving forward.

 

[audreyh1]

Cool!

 

[Earl E Retyre]

The same LIVE OAK Bank CD is available: Cusip 538036VX9 ... 4.75% YTW 2032 maturity 3.65 coupon with $431,000 available. I bought some more this morning.