Bond Fund vs CD In the Next Five Years

The future depends on what you do today.

Last week’s article was more about how to buy a 5-year CD at PenFed that pays 3% APY. This article explains why someone would want to do that instead of keeping money in a bond fund.

Specifically, I want to answer this question:

Under what circumstance will a bond fund do better than a PenFed 5-year CD in the next five years?

I chose five years because that’s the term of the CD. As you may recall from a previous article, a bond fund can do better than a CD in the interim before the term is over even though it does worse over the full term. After the CDs mature, we start over and reinvest in whatever makes the most sense at that time.

For the comparison, I chose two bond funds: Vanguard Short-Term Investment-Grade Fund Admiral Shares (VFSUX) and Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX). For the moment I’m putting aside the difference in risk. I’m also throwing away the early withdrawal option in the CD. All I’m looking at is if I put the bond fund and CD into two locked boxes, reinvest all distributions, and re-open the boxes in five years, which box has a higher value. For simplicity I’m assuming both boxes are IRAs, with no tax consequences.

Of course no one knows the future. But with bond funds and CDs, we can project based on interest rate changes. There is a mathematical relationship between interest rates and bond values.

Short-Term Bond Fund

The SEC yield on Vanguard Short-Term Investment-Grade Fund Admiral Shares is currently 1.6%. It has a duration of 2.3 years. If interest rates go up soon, and they go up large enough, after an initial setback, the bond fund will earn more from the higher yield.

How soon and how large an increase will make the Vanguard Short-Term Investment-Grade Fund Admiral Shares match the return from 3% PenFed CD? Tomorrow, an increase of 2.7 percentage points.

If interest rates go up tomorrow, and the SEC yield on the bond fund increases from the current 1.6% to 4.3%, the fund will suffer a 6% loss right away but the remaining 94% will earn 4.3% for five years. After five years, the fund recoups the loss and ends up earning average 3% a year.

Are interest rates going up tomorrow and going up 2.7 percentage points from 1.6% to 4.3%? Never say never but very unlikely.

Any delay in the time of interest rate increase will only raise the size of such increase required to make the short-term bond fund produce the same return as the CD. For example if the interest rate on short-term investment-grade bond funds only starts going up one year from now, it must go up by 4.5 percentage points, not just 2.7 percentage points. Again very unlikely.

Intermediate-Term Bond Fund

It’s a different situation for an intermediate-term bond fund. The SEC yield on Vanguard Total Bond Market Index Fund Admiral Shares is currently 2.2%. It has a duration of 5.4 years.

Because of its longer duration, no amount of interest rate increases, no matter how soon, will make the intermediate-term bond fund match the return of the 3% PenFed CD in five years. If interest rates stay steady for five years, the fund will return 2.2%, plus a little more from bond trading, minus a little from bond defaults and downgrades. If interest rates go up, the return over the next five years will only be lower. The later the rates go up, the worse the return will be.

If interest rates fall, they can’t fall too soon, because then any boost to the bond prices will be chipped away by lower yield. The best case for an intermediate-term bond fund would be for interest rates to stay steady for four years and then fall in the fifth year. That way the bond fund suffers from the lower yield for only one year but it gets to keep the increase in bond prices.

Possible? Yes. Likely? I won’t count on it. That’s why I bought the 3% PenFed CDs. No guessing which way interest rates will go. In most cases the CDs will come out ahead.

[Photo credit: Flickr user symphony of love]

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  1. Michael says

    Nice analysis. It looks like there’s little downside to doing a 3% CD as opposed to buying bonds. The main risk seems to be that CD rates will themselves increase, in which case you would’ve done better to wait. But that’s always the case, and 3% is actually quite high for the current interest rate landscape. Moreover, if you wait, you’ll earn nearly zero in the interim with no guarantee of a future increase. Also, since you can pay a penalty to cash in your CD, it’s hard to argue against your view.

  2. Tom says

    Appreciate your analysis, previously you have stated that the situation can be different for those in higher tax brackets who are utilizing muni bonds. How does the 3% CD compare to Vanguards intermediate and limited term muni bond fund for those in higher tax brackets?

    • Harry says

      Munis are complicated by tax rates, national fund versus in-state fund, etc. In general, the story is the same for short-term munis. At only 0.85% SEC yield for Vanguard Limited Term fund with a duration of 2.3 years, it needs a large increase in yield, soon. Assuming 33% federal tax rate and 5% state tax rate, the yield on the Limited Term fund must go up by 2.2 points tomorrow or by 4 points one year from now in order to match the 3% CDs.

      Under the same assumption for tax rates, the Intermediate-Term fund can do better than 3% CDs if muni yields hold steady or go down. It can also tolerate a small increase in yield if the increase is small enough and it happens soon enough (to give the fund time to recover). The fund can tolerate a 1.3 point yield increase tomorrow. The tolerance goes down with time. A large, late increase in yield will make the intermediate-term muni fund do worse than 3% CDs in the next five years.

  3. paul says

    Using your time and interest example how long would it take for Vanguard Total Bond Market Index Fund to recoup its original NAV price? Thanks

  4. Harry says

    The fund’s duration says for every interest rate change, up or down, it takes 5.4 years following the change to get back to it original path (earning roughly 2.2% a year).

  5. Brian says

    I find this confusing.
    A bond fund is made up of a collection of bonds paying fixed yields.
    If rates jump up 1%, I understand how that makes that fund worth less if sold (because a new bond fund started that day would have access to higher paying bonds), what I do not understand is how that drops the yield of the original bond fund???

    You still own the same bonds in that fund, they are still paying out the same yields, why would your yield be impacted???

    Bond fund price being impacted I understand (but that should only impact you if you sell, right?), yield being impacted I can’t figure out.

    • Harry says

      The price and yield are two sides of the same coin. When price drops the yield goes up, not down — where do you see the yield would go down? The total return consists of both interest payments and price changes. Under the setup in the article, we are opening up the two boxes at the end of five years. If the bond prices are still down at that time, and not made up by increased interest payments, CDs win.

  6. Brian says

    I’m asking a more fundamental question about bond funds:

    If I own 100 shares of a bond fund (with 5000 bonds) yielding 3%, and rates jump 1%, decreasing the value of the fund 6%, shouldn’t I still be paid out a yield of 3% on the 100 shares I hold? In your example I’m paid 4% on 94% (it’s as if I have 6 less shares). Is my yearly payout based on the NAV and not the number of shares I hold?

    If I personally owned all 5000 of the bonds in the fund, and all of those bonds are yielding 3%, and rates jumped 1%, I would still be paid out 3% for the life of those bonds (and could use the payments to buy new bonds at 4%). ie there would be:

    1) a floor of 3%/yr payments
    2) with some upside if rates went higher (reinvest payments to buy more bonds paying higher rates)
    3) with some upside if rates went lower (could sell the bonds for more than you paid for them)

    So, is it better to own the individual bonds (if you could afford it) than the fund?

    • Harry says

      It will be less confusing if everyone uses the same terminology. The yield is calculated against the current price, not the original face value. When new bonds yield 4%, your old bonds also yield 4%. The absolute dollar amount you receive as interest payments stay the same but the yield calculated using the current price goes up.

      There isn’t much difference in owning individual bonds versus through a fund if you own them the same way. The bonds don’t know who owns them. They behave the same way. The bond funds used as examples in this article typically maintain a relatively constant maturity at all times. If you own individual bonds and you also maintain a relatively constant maturity at all times, you will get similar results as a bond fund. You basically become your own amateur bond fund manager. You will probably do worse due to less diversification and higher trading cost. See Individual bonds vs a bond fund on Bogleheads Wiki.

  7. Paul says

    How does today’s statement from the Fed effect the Total Bond fund?
    If you are in retirement and live off your portfolio and the duration of the Total Bond fund is 5.4 years, do we sell our bond funds and buy CDs or wait it out for many years? Thanks again

    • Harry says

      I don’t see a large effect. If I only have the Total Bond fund I would sell some and buy the PenFed CDs but still keep some some for liquidity and rebalancing.

  8. Jerome says

    I live in MA and have a good chunk of municipal bonds. VMATX yield as of today is 3.31%. And dividends are tax-free for me (federal and state). Sounds like a really nice deal, isn’t it? No reason I can see to buy a Penfed CD, then.

    Anything I am missing in such reasoning?

    • Harry says

      Vanguard reports the SEC yield on its Massachusetts Tax-Exempt Fund (VMATX) at 3.01%, not 3.31%, with an average duration of 7.3 years. Muni’s have a chance to do better (see previous reply to Tom under comment #2).

      However, I would be more careful with taking Vanguard’s reported numbers for long-term muni bond funds at face value. The reported average maturity and duration take into account the likelihood the bonds will be called before the stated maturity. The Portfolio & Management page shows 85% of the holdings have their maturity under 10 years. But if you click on the portfolio holdings link, you see very few of the top holdings mature in 10 years. Many holdings go out to 25 to 30 years. If interest rates go up, the likelihood for the bonds being called goes down. All of a sudden the average duration could become much longer than the 7.3 years you signed up for, which means a larger loss than you estimate now.

  9. Brian says

    Wow, great point. I live in CA and thought the duration of the VG CA muni funds were what they were, but looking through the actual holdings on the website, I see your point. Something I had not considered…great insight.


  10. Robert says

    Rolling yield convergence has been studied extensively. Those studies demonstrate conclusively that bond funds of constant duration (the typical bond fund), facing either a rising or falling-rate environment, experience yield accruals that offset the duration-based price effects. As the investment horizon lengthens, the role of accruals grows, leading to multi-year bond fund returns that converge toward the starting yield values (or beginning top tier of a bond ladder). These bond funds experience significant return volatility in the short term, but over the longer term, returns converge back toward the starting rolling yield. Investors with long horizons who are content with current yields have assurance that their long-term returns will be statistically close to the starting rolling yield. The most significant finding, and one that makes CDs a preferred choice in either rising or falling-rate environments, are the convergence horizon is constant at 2D-1 where D is the duration of the bond fund. The convergence horizon for the CD is its maturity date (or it’s D). Additionally, non-brokered CDs have a put option typically 3-6 months interest.

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