The case for substituting CDs for bond funds should be obvious but I’m surprised more people don’t realize it.
CDs are FDIC insured. Bond funds are not. CDs lock in the rate for reinvesting interest. Bond funds do not. The downside to CDs is limited to the early withdrawal penalty. There is no such floor in bond funds. Finally, CDs have a higher yield than many bond funds.
What’s not to like? There must be some misunderstandings about CDs.
Myth: You can’t buy CDs in an IRA
It’s true that some banks don’t sell IRA CDs. For example Barclays Bank does not. But other banks do. Ally Bank sell IRA CDs. So do CIT Bank, Discover Bank, PenFed, and many other banks.
Myth: You can’t buy CDs in an investment account
First you can buy brokered CDs in a brokerage account. If you don’t care for brokered CDs because they don’t have the best yields, nothing stops you from selling some from your bonds funds and moving that part to a bank or credit union to buy CDs. You can have multiple traditional IRAs or Roth IRAs with different custodians. Just do a partial transfer to the bank or credit union to buy CDs.
Myth: It’s difficult to rebalance if your fixed income investments are in CDs
You don’t have to be all-or-nothing: all CDs or all bond funds. Leave some money in bond funds for rebalancing and the rest of your fixed income investments can go into CDs. You don’t need 100% of your fixed income money for rebalancing.
A previous post shows it takes a 20-25% drop in the stock market to shift the stocks/bonds allocation by 5 percentage points. If you leave 10% of the portfolio in bond funds, that’s more than enough for rebalancing needs. If you normally invest 30% of your portfolio in fixed income, that means 2/3 of your fix income investments can go into CDs. If you normally invest 50% of your portfolio in fixed income, that means 80% of your fix income investments can go into CDs.
Your new money can still go into bond funds. The static pile stay in CDs.
Myth: You have to move from bank to bank for the best rates if you invest in CDs
If you buy CDs from a bank or credit union that offers good enough rates, you don’t have to move if you are satisfied with good enough rates. CIT Bank, Ally Bank, Discover Bank, Barclays Bank, and PenFed all offer good enough rates. One bank may be better than another for a specific term at one point of time, but the rates are all competitive with bond funds. Even if you move, it’s once 5 or 7 years when you are investing for the long term. What’s the big deal?
Bottom line: invest in bond funds and CDs, not bond funds or CDs.
[Photo credit: Flickr user UW-River Falls Archives]
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Dean Merrill says
Couldn’t agreed more with respect to the viability of CDs as a component in a fixed income portfolio. I’ve wondered for some time why it is that financial geeks typically ignore this timely asset class. Over the past quarter I’ve been steadily moving bond fund holdings into CDs in local credit unions where I am finding the best rates. Without exception, I’m able to lock in higher rates on 36 month CDs than I would have earned in bonds with much longer durations plus I’m gaining price stability and government insurance. I appreciate the timely articles! Keep up the good work.
Have no idea why this is not discussed more.
Harry, I’d be interested in your opinion on this with CDs now at 1% – 1.6%. Thanks
Harry Sit says
No change. Still favor CDs. The rate depends on the term and where you buy the CD. I just transferred part of my IRA to a credit union to buy a 7-year CD at 3%. See Transfer IRA From Mutual Fund To Credit Union For CDs.
Fixed maturity corporate bond fund ETFs from Guggenheim (BSCM for example), Blackrock and maybe others have better YTM rates than CDs and are far more easier to hold in a brokerage account without the need to open new accounts and tranfer funds around. It gets cumbersome chasing around rates and these fixed rate ETFs make it really unnecessary anymore.
Marty, it is true that you can get higher yield by venturing down the credit spectrum. HYG and JNK have higher ytm than BSCM, but that’s because they have more risk, just like BSCM is riskier than CDs.
An apples to apples comparison for CDs are treasuries with the same maturity because both have 0 credit risk. Corporate bonds drop in price during credit crunches, times when most likely, equities are dropping too. Treasury and CDs do not. It’s all about having a purpose for the asset you’re holding.