Short-Term Fixed Income: CDs vs Bond Funds

The interest rates are really low these days. If you are trying to rollover a matured CD or if you want to save for something you need in a few years, it’s not easy to find a good option.

After rolling over my IRA to my solo 401k at Fidelity, I want invest a small sum in the solo 401k account in short-term fixed income. I went and looked at my  options.

Treasuries

I can buy Treasury notes from Treasury auctions. Fidelity doesn’t charge me any fee for that. The problem is the yields are so low. According to Bloomberg, the current Treasury yields are:

1 year 0.34%
2 years 0.97%
3 years 1.50%
5 years 2.35%

If I buy an equal amount in these, my average yield will be 1.29%. I’d like to do a little better than that.

Bond Funds

Fidelity has a low cost short-term Treasury bond index fund. The problem is because it invests in Treasuries, the yield on the bond fund is also very low. A bond fund can’t earn more than the underlying bonds do.

Fidelity also has a short-term bond fund which invests in Treasuries and government agency bonds (~40%), corporate bonds (~25%), and other bonds. It’s more expensive. I’m also wary of the alphabet soup in the fund: MBS, ABS, CMBS, CMO.

Vanguard has a short-term investment grade bond fund. Fidelity charges $75 for the initial purchase and $5 for each subsequent purchase if I set up an automatic investment plan. The Vanguard fund invests less in Treasuries and government agency bonds (~10%) and more in corporate bonds (~60%). It also has about 20% in asset-backed and mortgage-backed bonds (securitized credit card and consumer loans). The yield on the Vanguard fund is little higher than the yield on the Fidelity fund because the Vanguard fund has less in Treasuries and more in corporate bonds, and because it’s less expensive.

Expense Ratio 30-Day SEC Yield Duration
Spartan Short-Term Treasury Bond Index Fund (FSBIX) 0.20% 1.12% 2.7 years
Fidelity Short-Term Bond  Fund (FSHBX) 0.45% 2.21% 1.7 years
Vanguard Short-Term Investment-Grade Fund (VFSTX) 0.26% 2.64% 1.9 years

The duration of a bond portfolio indicates its sensitivity to interest changes and the amount of time it takes to recover from an interest rate increase. Because interest rates are low, I’d like to keep my duration low.

Bond ETFs

Like index funds, ETFs have low expense ratios. The commission on purchasing an ETF is a lot lower than the $75 Fidelity charges for buying a Vanguard fund. I already know a Treasury ETF can’t do any better than Treasuries I can buy myself. If I buy an ETF, I’m only interested in a corporate bond ETF.

Vanguard Short-Term Bond ETF (BSV) is the ETF equivalent to its short-term bond index fund. It has 70% in Treasuries and agency bonds. iShares Barclays 1-3 Year Bond ETF (CSJ) invests primarily in corporate bonds. I like its portfolio. The problem is it trades at 1% premium to the underlying net asset value (NAV). If I put $10,000 in it, I’m paying an extra $100 plus a $11 commission. That’s more than what I’d pay if I buy the Vanguard open-end fund.

Expense Ratio 30-Day SEC Yield Duration
Vanguard Short-Term Bond ETF (BSV) 0.14% 1.71% 2.6 years
iShares Barclays 1-3 Year Bond ETF (CSJ) 0.20% 2.37% 1.8 years

CDs

CDs offer a unique advantage to retail savers. When you buy Treasuries or bonds, either directly or indirectly through mutual funds or ETFs, you are competing against institutional investors. They set the price; you follow. You may also pay a markup to some middlemen unless you buy in Treasury auctions.

Retail savers rule in CDs. Institutions with hundreds of millions to invest can’t be bothered to open a $250,000 CD here and there. Treasuries will never be “on sale.” On the other hand, different banks will have different eagerness to attract deposits at different times. When one bank wants money more badly than another, they will have a “sale” on their CD rates. As long as the CDs are FDIC insured, you don’t care who’s putting the CDs on sale.

If you don’t mind the hassle of opening and closing accounts, you can shop the highest rates wherever they are. Bank Deals blog publishes a weekly summary of the best CD deals. Bank Deals is better than BankRate.com because Bank Deals does not limit itself to banks that pay its operator for the lead. As I’m writing this, the best deals I see on Bank Deals with a low minimum deposit requirement are:

1 year Alliant Credit Union 2.15%
2 years Hudson Savings Bank 2.50%
3 years Hudson Savings Bank 3.00%
5 years Melrose Credit Union 3.80%

If you compare these rates with the Treasury yields, you see the CD yields are much better. An equal amount in these CDs will earn an average yield of 2.86%, versus 1.28% in Treasuries. The best rate CDs have a higher yield and a lower risk than bond funds and ETFs that invest in corporate bonds.

Brokered CDs

Unfortunately opening accounts wherever the best deals are is not an option for me in my solo 401k account. My money has to stay within Fidelity.

Fidelity sells brokered CDs. These CDs are also FDIC insured. Instead of selling directly to individual savers, some banks sell their CDs through brokers. There is no fee for buying brokered CDs, but the best rates on brokered CDs don’t match the best rates on retail CDs. Here’s what I see in Fidelity:

1 year GE Money Bank 0.80%
2 years GE Money Bank 1.70%
3 years GE Money Bank 2.35%
5 years Republic Bank 3.00%

There’s quite a gap between these yields and the yields on best available CDs. If I put an equal amount in these CDs, I will have an average yield of 1.96%, still higher than the Treasury yields. The yield is somewhat lower than that on corporate bond funds and ETFs, but CDs have less risk.

Secondary CDs

Fidelity also sells secondary CDs. These are CDs other investors wanted to get out of before the maturity date. If I buy them, I take over the remaining term, very much like when one buys a bond on the secondary market. They are still FDIC insured. Fidelity charges a fee of $1 per $1,000 (min. $8). If the interest rate on the CD is above market, I will also have to pay a premium. I see these secondary CDs in Fidelity:

Maturity Date Bank Rate Price with Commission Yield with Commission
10/11/2010 Firstbank 3.65% 101.926 1.65%
10/14/2011 United Commercial Bank 4.40% 103.100 2.78%
10/29/2012 Capmark Bank 4.70% 105.271 2.87%
10/09/2014 Doral Bank 3.25% 99.643 3.33%

When someone wanted to get out early, they will have to offer a better yield than comparable new issue CDs. If I put an equal amount in these four CDs, I will get an average yield of 2.66%, higher than the yield on new issue CDs, matching the yield on corporate bond funds and ETFs with lower risk.

There is one caveat in secondary CDs: the FDIC call. The CDs are insured by FDIC for their face value plus accrued interest. If the CD’s interest rate is higher than market and I have to pay a premium, the premium I pay is not protected by the FDIC. In essence, I’m short a call option at par to the FDIC.

For example, paying $1,052.71 for a $1,000 CD from Capmark Bank with an interest rate of 4.7% will give me a yield of 2.87% if Capmark Bank doesn’t fail before the CD matures on October 29, 2012. If it fails tomorrow, I only get back $1,000 from the FDIC, and I lose $52.71. That’s a risk in buying secondary CDs.

If I buy secondary CDs, I will limit myself to CDs selling below 100 or CDs issued by well known too-big-to-fail banks.

Structured Products

Savers don’t like low interest rates. That’s for sure. I was waiting for someone outside a bank branch the other day and I saw some brochures and forms the in-branch investment advisors stacked by the window: index linked CDs and absolute return funds. They are targeted at people who are not satisfied with their CD rates. People want something for nothing. The advisors in the bank branches have a ready audience.

If you want safety, go with safety. If you want to take risks on the stock market for its higher expected return, go with the stock market. Blend the two and you will have a balanced portfolio. The structured products only enrich the producers and the advisors. I won’t touch them with a ten-foot pole.

After weighing all my options, I decided to do a mix of new issue brokered CDs and secondary CDs. This CD ladder I put together will have an average yield comparable to corporate bond funds and ETFs, but the CDs will have lower risk. The FDIC insurance comes as close to a free lunch as it can get.

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Comments

  1. enonymous says

    this is a great column – kudos to you – well researched and well thought out.

    I have a sort of related question – I currently hold the fixed income portion of my portfolio 50/50 in TIPS, and in U.S. intermediate treasuries (Fidelity’s Spartan Intermediate Bond Fund). All of my fixed income is held at Fidelity in 401k’s and IRA’s. Would it make sense to switch some of my fixed income to CD’s with a higher yield? – the duration of the Spartan Intermediate fund is about 6.5 years, so I believe that is about comparable to a 8 year, or so, maturity CD – on which rates are a bit higher than on the bond fund.

  2. Harry Sit says

    enonymous – Applying the same thought process, I think it makes sense to move some from Treasuries in the Spartan fund to CDs. You get a higher yield with no reduction in credit quality. Do note that CDs have lower liquidity. If you have to sell before the maturity date, your CDs become secondary CDs and you have to give some enticement to the purchaser. If you commit to holding them to term, I don’t see a problem.

  3. MS says

    Hey, I just ran into your blog when I was searching for some short term bonds.
    I have to say excellent posts. I also have to say that I am going through the same decision process for my wife’s account. I am deciding between adding 5000$ to her vanguard account to a short term muni bond fund (e.g. VWSTX) or just letting the money be in her ‘smartypig’ account which is offering 2% FDIC insured.

    What would you recommend? This money (all 5k of it) will again be dollar cost averaged out of the short term bond fund into her roth IRA throughout 2010. Her roth IRA is 100% in Vanguard 2030 Target date fund.

    Thanks for your input.

  4. MS says

    Following up my question – its obvious I am after the extra yield available from the short term bond. Also, moving the money into short term bonds and then pulling it out over the next one yr and moving into the 2030 fund means I am betting that rates wont change over the next year, and even if they do, my NAV losses are very limited because the bond duration is 1-2 years.

  5. Harry Sit says

    MS – If I were in the same situation, I would stay in smartypig. The first installment will come out of this pot in 3 months. The last installment in 15 months. The average holding period is only 9 months. Smartypig is safer and it earns more after taking taxes into consideration. Also realize after all is said and done, we are talking about a difference of a few dollars a month here.

  6. John says

    Just my $.02 on brokered CDs, and such.

    As a general rule, when you buy a brokered CD, you will get a lower yield than if you buy a CD yourself. The reason is obvious: the middle man (or woman).

    As another general rule, when you buy a brokered CD through a brokerage, you will get fewer options for purchase than if you went out hunting on your own. The reason: many issuers of CDs do not “broker” their CDs and many of the “best” CD deals these days are restricted to “local only”, whether they be by banks or credit unions.

    Brokered CDs are convenient, I give you that much. If you have a consolidated statement, you can see it all in one glance.

    But don’t be fooled. If you really, truly, want the best yields these days, you really, truly, have to go out shopping for the best retail CDs you can find. Try the “bankdeals” blog for starters. Credit unions always tend to offer better rates than banks (think tax laws).

    I know, I know, it’s a few basis points here and there. But if you go out long enough (e.g., five years), you can find retail CDs offering 3% or more. While that sounds puny, with inflation at 0%, it’s not too shabby. Always ladder, though, so when inflation rears its ugly head, your ladder will protect you.

  7. Harry Sit says

    John – I agree with everything you said. The sample rates I included in the post show how much one gives up in brokered CDs compared to the best deals available. The only reason I looked at brokered CDs is that I have a solo 401k plan. I can’t open solo 401k plan accounts at credit unions. I have to pick one provider for my solo 401k and only invest in what’s available from that one provider. If others don’t have this somewhat unique restriction, building a ladder with CDs from the best deals in the country is the way to go (Alliant CU for 1 year, Hudson Savings for 2 years, Melrose CU for 5 years, etc.). You can do that with taxable and IRA accounts.

  8. Art Cummins says

    Hi TFB,

    Thanks much for this excellent article on what to recommend in low interest rate environments. Do you check the quality of the bank issuing the CD’s?

    Also, do you have similar recommendations for taxable accounts? Muni’s,etc.
    Do you ever consider closed end funds?

  9. geezer investor says

    Thanks for the column. Of course, I like it because it tends to confirm my recent move into credit union CDs and money market accounts was as good as I could do. I could not bring myself to ignore the financial strength of the credit unions I chose. I invested close to the insurance limit in two credit unions (a large percentage of our net worth, which may have to last as much as another 30 years of retirement). Maybe federal insurance is a slam dunk, but the federal government seems to be creating a huge, debt-related mess with unpredictable consequences. I am concerned that a strong financial institution may turn out to be better insurance than the federal government.

    I actually put very long-term money in one-year CDs. My thought is that fairly short-term CDs in a CD ladder may be the best way to deal with the possibility that rates will soon begin a steep, rapid rise. I just cannot see putting money into stocks that seem to be trading at high levels because buyers (institutional and otherwise) can finance the carrying of those stocks by borrowing at extremely low rates.

  10. ellen b says

    I wonder why open 4 cds for an average of 2.64 vs 1 vg bond fund for 2.86? Doesn’t seem like much difference. Anyway, i thank you for one of the best writeen and clearest explanations of these investments I’ve run across. For someone who is trying to learn, it’s a pleasure.

  11. Harry Sit says

    ellen b – I think you got the numbers backwards. The reason for the CD ladder is stated in the concluding paragraph: comparable yield with lower risk.

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