After reading my previous post Diversify Bond Funds with CDs, reader Matt emailed saying
"It sounds good but my bond fund returned 6%+ a year in the last few years. If I had bought CDs instead, I would’ve missed all the good returns. I don’t think CDs were yielding 6% when I bought my bond fund."
Before I break out the standard statement about past performance, I’d like to do a case study. What if you bought a CD instead of a bond fund say four years ago in 2009?
Vanguard shows that back in January 2009, Vanguard Total Bond Market Index Fund Admiral Shares had a SEC yield of 4.36%. Google shows that a 7-year CD from PenFed was at 4.5% APY at that time. Similar to the situation today, a 7-year CD had a slightly higher yield than the Vanguard Total Bond Market Index Fund four years ago.
Investors who bought the bond fund and the CD would have had these returns since then:
|2009 – 2012 average||6.1%||4.5%|
Matt is correct: in the last four years he received a better return in his bond fund than he would have in CDs. Because interest rates dropped, the bond fund had a boost from capital gains.
But wait, it ain’t over yet. The bond fund is only yielding 1.6% now. The CD is still paying 4.5%. The higher return in the bond fund so far came at the cost of lower returns in the future. This is very similar to funding one’s expenses by debt. Today’s joy comes at the cost of tomorrow’s pain. Over the full course of 7 years until the CD matures, assuming the bond fund’s returns in the next 3 years match its yield today, here’s what the returns would look like:
|2009 – 2015 average (E)||4.15%||4.5%|
A 7-year CD bought in 2009 would do better over its full 7-year life after all, even though the interest rate dropping nearly 3% in the last four years was very favorable to the bond fund. The returns from the CD are more even. You don’t feast today and starve tomorrow. You don’t worry about any purported bond bubble. You just collect interest and reinvest at the original yield, even and steady.
That was then. What about now? The Vanguard Total Bond Market Index Fund Admiral Shares has an SEC yield of 1.6%. A 7-year CD from Discover Bank pays 1.9% APY. Forget about the option to take an early withdrawal if interest rates go up. If you just stick to it for 7 years, I would say you will end up with more money if you invest in the 7-year CD instead of the bond fund.
Interest rate can’t drop another 3% in the next four years when it’s already at 1.6%. If a very favorable interest rate environment couldn’t push the bond fund to win over a CD bought four years ago, a less favorable environment won’t be able to do it for the bond fund today either.
[Photo credit: Flickr user smcgee]