Bond Basics 2: Are CDs Better Than Bonds? - YouTube

CDs better than bonds?

Yes, sometimes CDs are better than bonds.

That's next.

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A certificate of deposit (CD) offers a higher interest rate than a Money Market Fund or

a bank savings account but you don't have access to your money for a period of time

without paying an early withdrawal fee.

CDs offered by a bank or credit union are simple interest-only bonds that are sometime

very attractive.

The highest paying CDs have higher yields than Treasury bonds and give the small investor

a rare advantage over conventional bonds and brokered CDs.

For instance, today the annual yield on a 5-year Treasury Note is about one and a half

percent.

But, in contrast, the yield for CDs with equivalent term and risk varies from a high of 3% to

nearly zero.

Wow, that's quite a range, isn't it.

CDs are like bonds in that they provide fixed monthly payments but cannot guarantee the

full return of principal before the end of the term.

The amount of the early withdrawal fee is limited: commonly 3 to 12 months of interest,

depending on the bank or credit union.

While that's generally true, look at this: this credit union offers an exception for

CDs in IRA accounts if you are over some age.

I don't mention this to advertise this credit union, but rather to emphasize the point that

while the bond market is incredibly efficient, the CD market is not, and that creates some

attractive opportunities for individual investors.

Now it's time for some fun.

I'll give you two facts.

You choose the fact that is true.

Here's one: Sometimes CDs are better investments than bonds.

Here's the other: Large institutional investors invest in CDs.

This is False.

CDs are issued to individuals by banks or credit unions, and insured by these federal

agencies.

So CDs -- like U.S. Treasury Bonds -- have essentially zero credit risk.

But the FDIC or NCUA insurance levels are limited to amounts that make CDs attractive

to individuals, but inappropriate for large institutional investors.

This is True.

Keep in mind that Bank CDs aren't negotiable -- meaning, you can't sell them in any market.

To redeem them you must go back to the bank (or credit union) where you purchased it.

But as I have showed, sometimes CDs are offered at above-market interest rates with low early

withdrawal fees.

If you can lock-in a CD with a higher rate than the equivalent Treasury Bond, then you

obviously come out ahead for no additional credit risk.

If interest rates go up, it can be even better!

I'll show you with a simple example.

Here, you buy both a 4% CD and a 4% Note.

Towards the end of the first year, interest rates increase to 5% and you'd like to replace

both to take advantage of the higher interest rates.

To sell your CD you will have to pay an early withdrawal penalty, which we'll say is 3 months

interest for this example.

Our annual interest rate divided by 12 is the interest rate per month, which we'd multiply

by 3 months to get the early withdrawal penalty.

Note that it remains one percent of the amount of the CD for any day after that until the

CD matures.

But an ordinary bond is different.

There is no early withdrawal penalty, but its price changes every time the interest

rates changes, and the amount the price changes gets smaller as the bond approaches maturity,

or more precisely, as the bond duration approaches zero.

Remember, we bought this bond one year ago so there are now four years left on this bond.

For now, let's say the duration is also equal to four years.

A bond price always changes in the opposite direction as interest rates by an amount equal

to the rate change times the duration.

So our simple estimate is that the cost to refinance the bond is four times more than

the CD, which is our point.

Sometimes, CDs are better than bonds.

Again, you're not going to get rich with bonds, but bonds are a critical elements for controlling

the level of risk in any portfolio, so it's vital that you understand the basics about

how they work.

Now if you understand how CDs work then you are well on your way to understanding how

other bonds work.

That's next!

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