Back in December 2013 and January 2014, I bought 5-year CDs from Pentagon Federal Credit Union (PenFed). Those CDs paid 3% APY when other 5-year CDs were paying a little over 2%. The yield on a bond fund, such as Vanguard Total Bond Market Index Fund, was about 2.3% at that time.
I bought the PenFed CDs because I estimated that regardless what interest rates would do over the ensuing five years, chances were slim that the bond fund would beat the PenFed CD. If rates stayed low, the bond fund would earn the lower yield. If rates went higher, the higher yield would first have to offset a principal loss. Five years flew by. My CDs matured. Let’s see how they did relative to Vanguard Total Bond Market Index Fund.
In order to compare with the reported annual returns for the bond fund, I assume the CDs were bought on January 1, 2014. Here are the year-by-year returns:
| Vanguard Total Bond Fund | PenFed CD | |
|---|---|---|
| 2014 | 5.89% | 3.04% |
| 2015 | 0.40% | 3.04% |
| 2016 | 2.60% | 3.04% |
| 2017 | 3.56% | 3.04% |
| 2018 | -0.03% | 3.04% |
| Annualized | 2.46% | 3.04% |
In the very first year, the return from the bond fund was almost double the return from the CD. That prompted some regret. It shows that in the short term anything can happen. Even when the PenFed CD looked like a better way to go, the bond fund still did much better in the first year. By the end of the second year though, the CD caught up. The CD did slightly better in the third year and slightly worse in the fourth year.
The fifth year made all the difference. The bond fund was flat. The CD still earned the guaranteed 3% interest. Over the entire 5-year period, the annualized return from the bond fund was 2.46%, versus 3.04% from the CD. When we look at the end value, the CD beat the bond fund by about 3%. When we look at the total interest earned, it’s as if the CD earned one extra year of interest.
A side benefit of the CD is that the returns were stable and predictable. You knew from the start what you were going to get, whereas the bond fund returns fluctuated and there were always worries how the Fed or whatever market forces would impact its returns.
Still, both the bond fund and the CD are fixed income. A difference of 3% over five years is something, especially relative to the low returns, but from a large picture’s point of view, one could say they performed similarly. The CD did better only because the credit union offered a higher rate than the prevailing yield on the bond fund at that time. Despite the year-to-year fluctuations, the bond fund didn’t do too badly. Because all the difference was made in the fifth year, it could’ve gone the other way in a different market environment. If you’d like to keep it simple and you just don’t want to mess with CDs, using a bond fund as 100% of your fixed income investments still works.
However, if you are willing to do a little bit of extra work, when a bank or credit union offers an above-market rate, you can do better. So instead of looking at CDs or bond fund, we should look at CDs and bond fund. They both have their place.
That was five years ago. What about now?
The options I had in What To Do With A Maturing CD back in September are still applicable. The yield on Vanguard Total Bond Market Index Fund is 3.2% now, about 1% higher than 5 years ago, but I don’t see banks and credit unions offering 4% CDs. A 40-month certificate from Navy Federal Credit Union at 3.75% APY comes close, but it’s only available in an IRA or Education Savings Account and its membership isn’t open to everyone. I’m putting my matured CD into a bond fund until I see another CD offer I can’t refuse.
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desper-otto says
I did the same thing. My PenFed CDs matured at Christmas this year. I decided against renewing with PenFed for the reasons you cited, and also due to PenFed’s draconian early-withdrawal penalties. I tried to ACH-transfer my funds and learned, to my surprise, that I could only transfer $5K per day. When I tried to transfer $5K on the second day, I learned that I could only transfer $5K every three days. I had started with $50K, and it’ll be the end of January before I can get it all transferred. PenFed pointed out that I could pay for a wire transfer, and transfer it all at once. I declined.
Harry Sit says
You pull the money out by requesting the ACH from your other account.
Craig says
Thanks Harry,
It was a pleasure speaking with you at the South Bay Boglehead meeting the other night. I always enjoy reading your blog articles they’re very enlightening. I just wanted to confirm you are using the Vanguard TIPS fund as your bond fund? Is this correct? Good advice for desper-otto about moving cd money to either checking or saving and then moving the entire lot out of PenFed, I did the same thing you do.
Harry Sit says
The short-term one, VTAPX.
Pat Ryan says
Very timely article, thanks Harry! Timely since we copied you in the PenFed move 5 years back. Also glad I read the comments because my CD maturity is coming up and I’d have run into the same thing.
East Coast says
Hi. You have VTAPX as your bond fund, but above you’re comparing the returns for VBTLX vs the PenFed CDs?
Harry Sit says
VBTLX was the alternative five years ago. I’m using VTAPX now for reasons specific to myself, unrelated to this post. The average annualized return of VTAPX in the 5-year period was 0.54%, far lower than the total bond market index fund or the CD.
FinancialDave says
Harry,
Bonds are volatile as you know.
Were the dividends and interest reinvested along the way? They must not have been otherwise the CD would have paid out increasing dollars each year after the first.
If you do this test again a better trial is to hold the bond fund and the CD for the effective duration of the bond fund you buy. This is how you invest in bonds. You DON’T buy a 6 year duration bond when you know you might sell it a year down the road — the same with stocks, unless you like losing money.
Buy the way your bond did exactly what it was suppose to do and not much more. You bought a bond with a 2.3% yield and your return was 2.46% — if you get more than what you bought consider yourself lucky.
By the way if the interest is reinvested you can likely get more than what you “bought into.”
In your case you bought a 6-7 year duration bond and only held it for 5 years so consider yourself lucky.
Harry Sit says
All interest and dividend payments were reinvested. The CD paid out an increasing amount in dollars but the year-over-year returns were the same. They are calculated from the prior year balance, not from the original investment. We can continue the comparison for another year or two. For the record PenFed currently offers 1-year CD at 2.8% and 2-year CD at 2.95%. Rates are slightly higher elsewhere but we assume we just renew with PenFed for convenience.
Craig says
I watch the fixed income yields on Fidelity’s site (https://fixedincome.fidelity.com/ftgw/fi/FILanding) & CD’s on depositaccounts.com. The only bonds you can buy that beat CD yields meaningfully are junk corporate bonds. Also, Depositaccounts shows CD’s with higher yields than what is available at Fidelity.
For the small investor, I just cannot find a good reason to buy bond funds in today’s environment. Varying maturity of CD’s, between brokered and new CD accounts at various banks/CUs, offer the safest return at yields that beat Treasury bonds and investment grade corporate bonds. Brokered CD’s offer price appreciation (like bonds) if interest rates decline on secondary market.
FinancialDave says
Harry,
I revisited this today from another thread and did a more detailed dive as your comment:
“…chances were slim that the bond fund would beat the PenFed CD. If rates stayed low, the bond fund would earn the lower yield. If rates went higher, the higher yield would first have to offset a principal loss.” Did not seem to address what happens when rates go lower (your comment was “if they stayed low.”)
In your trial case, the bond funds nominal interest was 2.3%, which is what you bought into, as I mentioned. However, in 2014, 2016 & 2017 rates went lower driving up the total return of the bond fund from the what is called the “capital return” of the bond fund.
So at the end of year 4, the bond fund was actually ahead $11,289 to $11,255. Not a significant amount, but ahead none the less. The only reason the bond fund lost out was due in fact to sharply rising rates in 2018.
Like I said, in general, you can not always compare the nominal rate of the bond fund to a CD rate and think you know which side will win over time. CDs are more risk-free, so generally if you can get an equal or greater rate you are probably safe to take it, but comparing the two is not a fair comparison just due to the “randomness” of interest rates and the market.
Harry Sit says
Chances were slim but it doesn’t mean it was impossible. Later I said it could’ve gone the other way in a different market environment. However, a large margin between the initial yields gives the CD a cushion. I just bought a 5-year CD at 3.5% today versus the 2.5% yield on the Vanguard Total Bond Market Index Fund. Over the next five years, I’d say odds are in favor of the CD. Not 100% guaranteed of course, but I think the margin is large enough to make the CD resilient to the randomness in the next five years.
indexfundfan says
What a difference 8 months make! The total bond index has returned more than 9% in the first 8 months of 2019.
Harry Sit says
Yes, back to CDs now. 5-year @ 3.5% (Navy Fed, 3.25% now). 5-year @ 3.0%/3.25% with add-on (GTE, regular/jumbo). Compare to 5-year Treasury at 1.37%. The yield difference between 5-year CDs and the total bond index fund is higher now than at the end of 2013.
indexfundfan says
Agreed. BTW, the GTE offer ended last Friday.
east coast says
These CD yields are higher than the total bond market index yield, but as was written above, the index has returned more than 9% YTD. If this keeps up, doesn’t that make the bond index a better choice? Thanks.
Harry Sit says
We saw that in the last round as well. If you look at the table in this post, you see the bond fund made 6% in the first year whereas the CD only made 3%. The CD eventually caught up. If you can time when the bond fund will stop going up, like after another year in our example, you can stay in the bond fund until that time. But then what? The available rates at that time will also be lower. I think over a full 5-year cycle chances are good the CDs I bought recently will do better, just like last time.
Benjamim Wood says
I think because I have a conservative profile, I don’t like to invest more than 5% ….