Back in October 2015, I bought into a CD special from Northwest Federal Credit Union. It was a 3-year CD at 3%, which was a very good rate at that time. That CD is maturing next month. Another reader also bought into this CD at the same time. She asked me what I would do with the money after the CD matures.
It’s simpler for me personally because after I left my full-time job I no longer have paychecks. I will need money for my expenses next year. So I will just divide up the money and buy some 3-month and 6-month Treasury bills, timed to when I will need the money for spending.
What if you don’t need the money for spending? I see several good options.
Pay Down the Mortgage
A small part of the money from my maturing CD will also go toward paying off my mortgage. Under the new tax law many people will just take the standard deduction. Mortgage interest will no longer give them an extra tax deduction. In that case if your mortgage is in the 4% range, paying down the mortgage gives you a 4% after-tax return.
However, paying down the mortgage is more like a one-way street. It may not be a good option if you need the money for something else in the future.
Another CD
Interest rates on CDs came up this year. 3% was a great deal 3 years ago. Nowadays it’s very easy to find another CD above 3%, although it’s still rare to see something offering 4%, let alone 4% after tax. In essence 4% has become the new 3%. The best rate I see on DepositAccounts.com is about 3.3%.
Treasury Note
Buying a Treasury note is another option. The best CDs from credit unions used to offer a much better rate over Treasuries. When I bought the 3% CD 3 years ago, the yield on a 3-year Treasury note was only 0.9%. Now the gap between the best CDs and comparable Treasury notes is much smaller. When you take into consideration that Treasuries are free from state income tax, the difference shrinks further.
U.S. Treasury sells 2-year, 3-year, 5-year and 7-year Treasury notes every month (see calendar of announcement dates). See Daily Treasury Yield Curve Rates for where the yields are for different maturities. You can buy them directly in your Vanguard, Fidelity, or Schwab brokerage account. The process is similar to how to buy Treasury bills. You see the note offered in late morning/early afternoon on the announcement date. You place your order and you just wait.
Bond Fund
If hunting for another CD or buying a Treasury note is too much hassle, putting the money in a bond fund would be the simplest. Yes there will be price fluctuations, but over time it evens out with reinvested interest.
Don’t fall for the “interest rates will go up” talk. Interest rates have gone up. Whether they will go up further, and if so by how much, aren’t very clear. Bond prices at set by the market with their expectations of future directions. If everyone knows interest rates will go up a lot, nobody will buy the bonds at prices we see today. They will just wait to buy them at lower prices later. Enough people waiting causes the prices to arrive at where they are today.
There are bond funds of different types and terms. I would treat all prices as fair. You pick by the level of risk you’d like to take. Short-term bond funds have lower risk and lower expected returns than intermediate-term and long-term bond funds. Treasury bond funds have lower risk and lower expected returns than corporate bond funds. Bond index funds that include both Treasury and corporate bonds are somewhere in between. Muni bond funds are federal income tax free, good for taxable accounts in higher tax brackets.
Forget about picking a “sweet spot.” There are no sweet spots in bonds. If we can figure out where the sweet spots are with some rudimentary analysis, institutions with powerful computers and sophisticated tools would’ve been there ten steps ahead already. They don’t leave sweet spots for us to discover.
I have more CDs maturing in December. I’m planning to put that money in Vanguard Short-Term Inflation-Protected Securities Index Fund (VTAPX). This fund invests in short-term TIPS — inflation indexed Treasuries with maturities of up to 5 years. The expense ratio is very low at 0.06%. Holding TIPS in a fund makes tax reporting much easier than holding individual TIPS in a taxable account. I’m picking this fund because I’d like to have inflation protection and low level of risk when that money will fund my spending in the next several years.
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Steveark says
Best common sense analysis of bonds I’ve ever read! There are so many people crying wolf about bonds and interest rates when common sense says that the market adjusts as things change and supply and demand always wins out in the end. When I read your post I immediately thought, “I wish I had written that!” But I couldn’t have done it half as well.
Jim says
With QE there is no such thing as supply and demand.
John McKissick says
I fully agree also and appreciate this analysis also. A Vanguard analyst recently said (paraphrased) that the best indication of the future value of a bond is the current price.
DB says
I enjoy reading your blog posts and find your writing style clean and well thought out.
One question: why is holding TIPS in a fund makes tax reporting much easier than holding individual TIPS in a taxable account? Does not the treasury send 1099 form reporting the interest earned? I seem to remember receiving something similar when I sold some savings bonds a few years ago.
Thanks.
Harry Sit says
When TIPS are held in a fund, the fund distributes the income and sends you a 1099 as any other bond fund. When you buy individual TIPS, the price you pay may be at a discount or a premium. If you paid a premium, it’s to your advantage to amortize that premium over the years to offset the higher interest you receive. You will have to do that calculation. If you paid a discount, you will also need to keep track of the discount and report it as income when the TIPS matures. If you sell before maturity, you have more complication in calculating capital gains when you already paid taxes on inflation adjustments. Savings bonds are much simpler because all taxes are deferred to the time you sell.
DB says
Thanks Harry. That is very helpful to know. Is this premium/discount complexity also true for treasury bills and notes?
What if these instruments are purchased at par and you hold them to maturity? Is interest earned the only thing to be reported in the tax return each year? In that case, is 1099 all you need to report the interest?
Are there any good resources on how to correctly report TIPS and bond income for taxes? Do Tax SW like Turbo Tax help with these?
Harry Sit says
No complexity for Treasury bills because you just wait until the bills mature and report the price difference as interest. No much complexity for Treasury notes bought at the initial auction either because they determine the coupon rate to make you always pay a slight discount. That discount is quite obvious when the note matures. It’s not possible to buy exactly at par. There can be some complexity if you buy Treasury notes on the secondary market, but it’s still less complex because there is no inflation adjustment. The best way to deal with tax reporting complexity in individual TIPS is simply avoidance. Hold them in an IRA or use a fund.
FinancialDave says
Harry,
I don’t really see your reasoning for passing up a 3.3% 3 year CD that is guaranteed, over a bond fund @ 2.1% with a duration of 2.6 years.
Unless you hold the bond fund past its duration, you could actually lose money.
Maybe you make out on a short term interest rate flucuation, but you could just as easily lose on one.
Why don’t you do a little “learning excercise” and do half in CD and half in bond fund and then report back in 3 years. Feel free to calculate the after-tax gain on each.
Don’t know what value to put on the security of your money in the CD, but it should be somewhat of a factor if your plan is to use the money any time in the near future. If you don’t plan to use it then maybe an I-bond is appropriate.
Harry Sit says
They are all good choices. I’m planning to use the short-term TIPS fund for convenience. I can still change my mind in December if a credit union comes out with a deal I can’t refuse, like the one 3 years ago when the rate offered was 2.1% above Treasury. Today’s yield on 3-year Treasury is 2.8%. I’m counting on the bond market to make the expected return on a basket of short-term TIPS to match that 2.8% number. Then the 3.3% rate on the CD is only 0.5% higher, which isn’t nearly as a screaming deal as before.
Doing a “learning exercise” will be a little complicated for me in that I’m planning to spend all the interest and also draw it down once a year as I need more cash for spending. I can’t do that easily with a CD. I can set up a year-by-year CD ladder, but it looks too rigid to me. I haven’t got into a routine yet. My expenses may vary greatly from year to year. The CD ladder also doesn’t have inflation protection.
FinancialDave says
Harry,
I humbly suggest if your plan is to draw it down every year, you do not want to be in a bond fund with a duration of 2.5 years. The duration should match your usage need otherwise you can get burned. If your plan is to use VTAPX, I suggest you do a little research and compare it’s recent payouts (normally once or twice a year at less than 1%) and then it’s price action which has been somewhat lower over the last year. A good measure of this is the 12 month total return on this fund which is .74% as of today.
I suggest a much safer play (with probably more yield), if you have a Vanguard account, is to put the money in VMMXX Money Market. No problem spending the more than 2% yield and your principal is pretty much guaranteed – certainly more than the bond fund.
Harry Sit says
Thank you. I will think about it in the next couple of months. The money will be drawn down over 5-10 years. I’m not too concerned about small fluctuations. Over time it should do better than money market. Rebalancing will also make me buy more bonds in tax advantaged accounts as I draw these down in taxable account.
Gordon says
During the time (the last 30 years) that most of us learned everything we think we know about bond funds, the yield on the 30-year Treasury bond declined at a relatively steady 0.25% per year (9/1988-9/2016). This is like a tail wind on the principal side. Has anyone seen a convincing numerical proof of the hypothesis that bond funds won’t lose money (over a reasonable term–5 years say) if 30-year Treasury yields rise at 0.25% per year for the next 10 or 20 years? Of course, it depends upon whether the bond fund in question is short duration or long duration, but assume 6 point something years, like VBTLX, VCOBX, and VBILX. People are still recommending these funds as core “income” positions . Do they truly know what they are talking about, or do they only believe based on what they’ve learned over the course of their lifetimes, when there was always a consistent tailwind? Are we in danger of running out of fuel (i.e., principal) if we encounter a steady headwind?
jim says
I bought that same northwest cd. I’m just gonna roll it into a 3.54% 4 year cd at a local bank.
TJ says
I’ve been thinking about Vanguard Ultra Short Term Bond Fund. Yield is 2.5%, the NAV has been pretty stable. My savings account currently is at 1.8%.
A couple years ago, the savings account was higher.
FinancialDave says
Each time interest rates kick up, the Bond fund NAV will tick down. Depends on if that matters to you. If you don’t plan to use the money and it’s just going to sit there then the short term bond fund is probably ok, However, the Vanguard Prime money market (VMMXX) is already earning 2.03% as of last month and every time rates “kick up” your dividend will go up and you will not have a “kick down” in your principal.