Because Fidelity administers my solo 401(k) plan, I can buy only what’s available through Fidelity. I looked at new-issue brokered CDs. The yields are lower than the best rates available from other banks and credit unions.

Then I looked at secondary CDs. Secondary CDs are like "pre-owned" cars. They are being sold by bond dealers. The dealers bought the CDs from the previous owners, who for one reason or another decided not to hold the CDs to maturity.

The good thing is that these "pre-owned" CDs still carry the same FDIC insurance. The banks are still obligated to pay the originally stated interest rate on the CDs. They don’t care whom they pay the interest to.

I guess because of the "pre-owned" image, and because the previous owners took a hit when they sold before maturity, secondary CDs have a higher yield than new issue CDs. Who wants a used one when they can buy new for the same price? A secondary CD must be priced lower than a new CD. A lower price means a higher yield.

The previous owners’ loss is my gain. I was able to pick up some good secondary CDs: 2.3% for 2-year and 2.95% for 3-year. These yields are almost as high as the best rates available elsewhere.

I paid more than the face value for some of the secondary CDs. Because the stated interest rates on those CDs are higher than the current market yield, I had to pay as much as $1,050 for each $1,000 CD. As I mentioned in the previous post, the amount I pay above the face value ("par") is not FDIC insured. The premium CDs have a risk for the "FDIC call" if the bank fails. For these CDs, I only buy if the issuing bank is too big to fail. I bought premium CDs issued by:

• LaSalle Bank N.A. – owned by Bank of America
• Wachovia Bank FSB – owned by Wells Fargo
• World Saving Bank – owned by Wells Fargo

I don’t think FDIC will close Bank of America or Wells Fargo in the next few years.

I paid below the face value for two other CDs from banks I’ve never heard of:

• R-G Premier Bank of Puerto Rico (1-star on bankrate.com; 0-star on Bauer Financial)
• Carolina First Bank

Since the CDs are fully FDIC insured, I don’t worry about the banks. When I pay less than the face value, I’ll actually make more money if these banks fail. Let’s see how long R-G Premier of Puerto Rico lasts.

Good secondary CDs don’t show up every day. I use this bookmarklet to screen them. The bookmarklet opens three browser tabs. The first tab shows the new issue CDs. That’s the benchmark. Secondary CDs must beat new issue CDs to become worthwhile. The second tab shows secondary CDs selling below face value. I don’t have to worry about the banks for these CDs. The third tab shows secondary CDs from banks with a Moody’s rating of A3 or above and a yield of 2% or more. If I’m paying a premium, the bank had better be strong and the yield had better be good.

Good secondary CDs also don’t last long. One time I saw a good CD but I took about a minute to make up my mind. By the time I attempted to enter the order, it was gone. Someone else beat me to it.

Fidelity charges a small commission for secondary CDs: $1 per $1,000 CD and minimum $8 per order. Their quotes don’t include the commission in the yield calculation until you are in the middle of placing an order. I made a spreadsheet to calculate the after-commission yield:

CD Ladder Spreadsheet

The spreadsheet also calculates the weighted average yield and duration for a CD ladder. If you like managing a CD ladder, you may find the spreadsheet helpful.

Treasure hunting in secondary CDs takes a little time. So does chasing yields by opening accounts everywhere. If you think it’s too much trouble, you can just stick to a "good enough" place like Ally Bank or Alliant Credit Union.

[Ally Bank pays me $20 if you open an account from my affiliate link.]

---
Software picked, likely related articles at The Finance Buff:

• Brokered CD and Bank Failures
• Buying TIPS On Secondary Market, Part 1: Why Secondary Market?
• Buying TIPS On Secondary Market, Part 4: What to Buy

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:

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.

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.

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:

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:

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:

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.

---
Software picked, likely related articles at The Finance Buff:

• No Change in I Bond Fixed Rate
• I Bonds Rate Guess for Nov. 1, 2006
• Brokered CD and Bank Failures