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.
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.
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.
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 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.
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.
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|
|10/14/2011||United Commercial Bank||4.40%||103.100||2.78%|
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.
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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