I wrote several articles about CDs as a good alternative to bond funds a few months back.
- Diversify Bond Funds with CDs (Feb. 4, 2013)
- CD vs Bond Fund: A Case Study (Apr. 22, 2013)
- Why Investors Don’t Realize CDs Are a Better Deal Than Bonds (Apr. 29, 2013)
- Why Financial Advisors Favor Bond Funds Over CDs (May 6, 2013)
I hope I made a convincing argument that prompted you to look into CDs, which helped you avoid some losses in bond funds. According to Morningstar, Vanguard Total Bond Market Index Fund lost 4.4% since May 1.
That was a loss of nearly 3 years worth of expected returns in 3 months. If interest rates stay at the current level, it will take another 2 years to fill that hole.
Will interest rates go up some more, which will bring more losses to bond funds when the Fed starts tapering Quantitative Easing? I don’t know. Nobody knows. My argument for CDs wasn’t based on predictions. CDs hold up well even when interest rates drop or stay the same. It’s not the same as parking in short-term bonds and earning a lower yield while waiting for higher rates, which may or may not come.
Now that interest rates are already up, is the argument for CDs less compelling than a few months ago?
Yes, it’s less compelling because banks and credit unions have not followed suit in raising CD rates. Not that they won’t, they just haven’t.
Banks and credit unions are still slow in moving CD rates up because they know people are still afraid of losing money in bonds if interest rates are expected to go higher still.
And they are right if interest rates actually do go higher still. In that scenario the best way would be to invest in CDs now and move back to bonds after interest rates are up, sidestepping the capital loss and only enjoying the higher yields afterwards. Any early withdrawal penalty will be much smaller than the capital loss caused by higher interest rates.
I’m not saying it will play out that way; nobody knows. I’m just saying banks and credit unions can still justify not offering higher CD rates after interest rates on the bond market are up.
The current CD rates are still competitive with bond yields after all. Vanguard reports the 30-day SEC yield on its total bond market index fund with a 5.4-year average duration at 2.05%. The rate on the best 5-year CDs is also in the neighborhood of 2.0%. If you buy CDs, you are not losing anything while you wait to see how interest rates play out.
Although less compelling as a few months ago, CDs haven’t lost their appeal yet. We are starting to see some higher rates in longer-term brokered CDs whereas rates on brokered CDs through a middleman used to be a lot lower than the best rates you can get by buying directly from banks and credit unions. That’s a sign that CD rates may be moving up soon.
Read more about those brokered CDs in Higher Yield On Brokered CD vs Early Withdrawal Option.
[Photo credit: Flickr user Horia Varlan]