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]