Bond Basics 2: Certificate of Deposit: Better Than Bonds? (video)

– Posted in: Investing In Bonds

Every portfolio needs some portion of bonds, so everybody needs to learn about investing in bonds. Sometimes a certificate of deposit (CD) is better than a bond! Learn about the occasional advantage that small investors have over institutional investors in this episode.

Video Transcript: Is a Certificate of Deposit Better Than a Bond?

Certificates of deposit: better than bonds? Yes, sometimes CDs are better than bonds. That’s next.

A certificate of deposit (CD) offers a higher interest rate than a Money Market Fund or a bank savings account but you don’t have access to your money for a period of time without paying an early withdrawal fee. CD’s offered by a bank or credit union are simple interest-only bonds that are sometime very attractive.

The highest paying CDs have higher yields than Treasury bonds and give the small investor a rare advantage over conventional bonds and brokered CDs. For instance, today the annual yield on a 5-year Treasury Note is about one and a half percent. But, in contrast, the yield for CD’s with equivalent term and risk varies from a high of 3% to nearly zero. Wow, that’s quite a range, isn’t it. (1)

CDs are like bonds in that they provide fixed monthly payments but cannot guarantee the full return of principal before the end of the term. The amount of the early withdrawal fee is limited: commonly 3 to 12 months of interest, depending on the bank or credit union.
While that’s generally true, look at this: this credit union offers an exception for CDs in IRA accounts if you are over some age. I don’t mention this to advertise this credit union, but rather to emphasize the point that while the bond market is incredibly efficient, the certificate of deposit market is not, and that creates some attractive opportunities for individual investors.

Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true.
Here’s one: Sometimes CDs are better investments than bonds. (T)
Here’s the other: Large institutional investors invest in CDs. (F)

This is False. Certificates of deposit are issued to individuals by banks or credit unions, and insured by these federal agencies. So CDs—like U.S. Treasury Bonds—have essentially zero credit risk. But the FDIC or NCUA insurance levels are limited to amounts that make CDs attractive to individuals, but inappropriate for large institutional investors.

This is True. Keep in mind that Bank CDs aren’t negotiable—meaning, you can’t sell them in any market. To redeem them you must go back to the bank (or credit union) where you purchased it. But as I have showed, sometimes CDs are offered at above-market interest rates with low early withdrawal fees.

If you can lock-in a certificate of deposit with a higher rate than the equivalent Treasury Bond, then you obviously come out ahead for no additional credit risk. If interest rates go up, it can be even better! I’ll show you with a simple example.

Here, you buy both a 4% CD and a 4% Note. Towards the end of the first year, interest rates increase to 5% and you’d like to replace both to take advantage of the higher interest rates.
To sell your CD you will have to pay an early withdrawal penalty, which we’ll say is 3 months interest for this example. Our annual interest rate divided by 12 is the interest rate per month, which we’d multiply by 3 months to get the early withdrawal penalty. Note that it remains one percent of the amount of the certificate of deposit for any day after that until the CD matures.

But an ordinary bond is different. There is no early withdrawal penalty, but its price changes every time the interest rates changes, and the amount the price changes gets smaller as the bond approaches maturity, or more precisely, as the bond duration approaches zero.

Remember, we bought this bond one year ago so there are now four years left on this bond. For now, let’s say the duration is also equal to four years.

A bond price always changes in the opposite direction as interest rates by an amount equal to the rate change times the duration. So our simple estimate is that the cost to refinance the bond is four times more than the CD, which is our point. Sometimes, CDs are better than bonds.

Again, you’re not going to get rich with bonds, but bonds are a critical elements for controlling the level of risk in any portfolio, so it’s vital that you understand the basics about how they work. Now if you understand how CDs work then you are well on your way to understanding how other bonds work—that’s next!

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Footnotes and Video Production Credits for Bond Basics #2: Certificates of Deposit: Better Than a Bond?

(1) Source: http://www.depositaccounts.com/cd/5-year-cd-rates.html

This video may be freely shared under the terms of this Creative Commons License BY-NC-SA 3.0.

Video copyright 2009-2014 Rick Van Ness.

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