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|
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.