2023-04-10 09:30:00 ET
Summary
- As the Federal Reserve signals that its rate will top out at 5% in May, higher yields in fixed income are slowly disappearing.
- The highest rates found in fixed rate investments change in a cyclical way as the fed's rate rises and falls. We pinpoint where we are in that cycle.
- We explore the advantages and hidden pitfalls of the Treasuries, Brokered CDs, and CDs bought directly from institutions that offer the best rates at different times in the rate cycle.
For the first time in their investing lives many investors who began managing their own portfolios over the last 20 years are discovering the benefits of investing in the kind of fixed income products that guarantee they will get back their full investment at a known date.
These investments were out of favor during the many years when interest rates hovered near zero, but now that the Federal Reserve is raising its Federal Fund rate to a level seen only for a single year over the entire past two decades, fixed income investments with known maturities have again become an attractive option for those seeking to generate income from their portfolios.
Bond Fund and ETF Investors Learned Harsh Lessons Last Year About Fixed Income Investments That Have No Fixed Maturity
The past year has taught a lot of younger investors some painful lessons about the bond funds the experts told them to use as safe "ballast" for their portfolios. Investors in funds like the Vanguard Total Bond Market ETF ( BND ), or long bond funds like iShares 20 Plus Year Treasury Bond ETF ( TLT ) saw shocking share price declines that negated any profit investors might have received from their relatively low dividend payments.
Shocked by the performance of bond funds in a rising rate environment investors who thought "bonds are for safety" are now discovering that this is only true when they invest in fixed income products that have a defined, unchanging yield and date when your principal will be returned--properties no bond fund ever has since they constantly buy and sell bonds and do not hold their bonds to maturity.
Dividend Stocks Are Less Appealing Income Generators When Fixed Income Rates Rise
During the decade plus of artificially low rates many retirees were forced to invest in dividend stocks if they wanted a better return than the paltry 1-2% they could get in fixed income. But some of those who invested in dividend stocks for income and who believe the market may enter a prolonged period of decline are thinking twice about the safety of funds invested in dividend paying stocks.
Why take risk when brokerage money market funds like Vanguard Cash Reserves Federal Money Market Fund ( VMRXX ), Vanguard Federal Money Market Fund ( VMFXX ) and Fidelity ® Government Money Market Fund ( SPAXX ) are paying yields ranging from 4.49% to 4.78%--especially when these rates will rise yet another .25% if the Fed raises its rate in May to a level near 5%.
These yields are already a percentage point than the distribution yields of the best dividend growth ETFs like the Schwab U.S. Dividend Equity ETF ( SCHD ), which yields 3.44%, or the Vanguard High Dividend Yield ETF ( VYM ), which yields 3.12%.
There are even completely safe FDIC insured 5 year CDs available now paying over 4.50%. Even with dividend growth it will take years for these ETFs to yield what these money market funds yield now--unless their share price plunges.
With the possibility of the U.S. entering a recession of unknown duration during which dividends may be slashed and stock prices hammered, the appeal of an investment that will preserve your capital and offer a better yield than stocks is looking better and better.
For the income investor the ladder strategy offers a way to sleep soundly at night no matter what the market does. This means investing a series of bonds and/or CDs of different maturities, so that not only is income generated steadily, but there is always a known amount of principal being returned every few months which the investor can spend on unexpected expenses or reinvest in the best option available at the time.
But as we will see, fixed income options follow a predictable cycle. And where we are in that cycle now suggests that the remarkable fixed income rates investors have seen over the past six months may not be available for much longer. So if you've been putting off the decision to invest in safe, fixed income with defined maturities, the time to act is now!
The Cyclic Pattern in Which Best Fixed Income Rates Appear and Disappear
Over my many years of buying fixed income investments I've noticed a pattern that usually repeats. When looking for fixed income investments with a defined duration, it isn't enough to know what the Federal Fund Rate might be. Because as the Federal Reserve raises or lowers its rate, different kinds of fixed income products offer the best safe yields at different maturities.
Here is how that cycle works--and where we are now in that cycle:
When the Federal Reserve begins to raise rates aggressively
Treasury bills maturing in 1- 3 months offer the best yields at first.
CDs whether offered directly by banks, credit unions, or through brokerage accounts offer the worst rates.
We were in this phase a year ago in May of 2022.
As investors start to believe rates will continue to rise
Longer treasuries extending out as far as 10 years offer the best rates, as do the 3- to 5- year maturity Brokered CDs that are offered by brokerages like Schwab, Vanguard, or Fidelity. This is the time to start filling up the longer rungs of your fixed income bond and CD ladder and locking in these excellent higher rates.
Whether Treasuries are a better deal for you at this time depends on whether you are investing in a tax sheltered account or not. In a taxable account a lowering yielding Treasury may pay a higher yield after taxes than a CD that offers a higher coupon if you live somewhere with high state or local income taxes.
At this time, CDs purchased directly from banks and credit unions still offer the worst rates.
We were at the height of this phase by October of 2022.
US 10 Year Treasury Bond Yield
When the Fed signals that it is going to slow down rate increases
The longer term treasury bonds' yields decline.
Brokered CDs going out 5 years still offer the best rates at the beginning of this part of the cycle.
Soon, however CDs you can buy directly from online banks and credit unions begin to offer higher rates than you can get from either treasuries or brokered CDs. This is the time to finish filling up any rungs that still are empty in your longer term CD and Treasury ladder.
Be sure to check out the CDs offered by online banks and credit unions before locking up money in brokered CDs.
For money you might need in the next year or two, short term treasury rates are still rising up to the level where the Fed signals it will pause. If you have had cash in money market funds You will earn more putting money you may need a few months in the future in 2- to 3- month treasury bills rather than a money market fund.
This is where we are now in this cycle!
Best Nationally Available Direct CDs as of April 09, 2023 (Earnings based on $25,000 investment)
When the Fed begins to cut rates
Grab whatever long maturity CD rates you can find that are still being offered directly by online banks and credit unions. Because bank CD offerings usually lag changes in the Federal Reserve rates by a month or two, there may still be some bargains to be had, but only for a short time.
No One Can Predict What the Fed Will Do Next Including the Fed
That is how the cycle works. But keep in mind that no one can be certain of exactly where we are in that cycle. Federal Reserve speakers now are all stating in public talks that they intend to hold rates steady for "some time," which several have defined as being at least to the end of 2023.
Whether they will back down if the economy tanks is open to question. But so is whether the economy will tank! It is even possible that inflation will continue to rise at a rate that requires the Fed to keep raising rates. With this in mind, the best strategy is to build out a ladder of bonds or CDs that will mature every 3 months or so over a 5 year period. This way whatever happens you will have money to invest in the fixed income products offering the best yields.
Benefits and Pitfalls of Treasuries, Brokered CDs, and CDs offered Directly by Banks and Credit Unions
Now that you have seen how the fixed income cycle works, let's look more closely at what you need to know before you buy any treasury bill or bond, a brokered CDs or a CD bought directly from a bank or credit union.
Please note I will not discuss buying corporate bonds here. Though they may be excellent investments for some people, they are more risky than treasuries and FDIC or NCUA insured CDs. Their behavior will vary with the fortunes of the companies who issued the bond and they may do poorly in an earnings recession. So buying individual corporate bonds requires the investor do the same level of due diligence as does buying individual stocks. The options we discuss here are far safer.
What to Know About Buying...
Treasury Bills and Notes
Treasury bills mature within a year. They are sold at auction every few weeks and can also be bought on the secondary market at most brokerages without your having to pay a commission fee. They sell at a price lower than their face value and return their face value when they mature. The difference between what you pay and that face value is used to compute their yield.
Treasury notes are sold at auction every month. They pay a yield based on their face value. They may sell at a small discount or premium at auction. They can also be bought on the secondary market without you having to pay a commission.
Some Treasuries Can Complicate Computing Your Taxes
Treasuries are not subject to state or local taxes. However, if you buy treasuries in a taxable account and bought treasury bills that don't mature in the same year in which you bought them or treasury notes sold on the secondary market you will face some complications at tax time. So if possible only buy these treasuries in a tax advantaged account, or buy them at auction only, unless are comfortable with accounting minutiae or use an accountant to do your taxes. Tax software won't automatically make some of the adjustments you will need to make though it will let you make those adjustments if you know you need to make them.
Where to Buy Treasuries
You can buy treasuries at auction directly from treasurydirect.gov. You can also buy them at auction through most major stock brokerages except for Robinhood. However, one of the advantages of buying treasuries is that they are very liquid. This means you can always find a buyer if you need to sell one before maturity, though you may take a loss if rates for the maturity you own have risen since you bought in. On the other hand, you may register a capital gain if yields have dropped since you bought yours. You can only sell a treasury if you bought your treasury at a brokerage. Treasury Direct does not let you trade treasuries. So it is only suitable if you plan to buy and hold until maturity.
Brokered CDs
Brokered CDs, as the name suggests, are FDIC insured CDs bought from a brokerage. You buy them at the same brokerages where you buy your stocks. I find Schwab's bond and CD interface the easiest to understand and use, but I am told you may get a few basis points better yield from Fidelity. I always found Vanguard's interface very confusing and rarely bought bonds or CDs there. Robinhood ((RH)) does not offer bonds or CDs.
Brokered CDs when newly issued pay a set interest rate based on the face value of the CD, which is what you pay. The interest is paid monthly or semiannually, depending on the issuer. When the interest is paid, it appears in your brokerage settlement account.
Brokered CD Interest Does Not Compound
The interest rates quoted for brokered CDs is the APR (annual percentage rate) not the APY that you see quoted for the bank and credit union CDs that you buy directly from a bank or credit union. The APY assumes that all interest paid during the life of the CD is reinvested and compounds. You will have to reinvest the interest from a brokered CD yourself. If rates go up, you benefit, if they go down, you make a bit less than you would have with a CD bought directly from the bank. But when brokered CD rates are much higher that the CDs offered directly by banks and credit unions this isn't an issue.
Beware of "Callable" Brokered CDs
They will usually offer the highest rates, but the issuer has the right to terminate them any time after some date specified in the disclosure for the CD. If rates go down, the CD is likely to be called. So you aren't locking in your rate the way you do with a non-callable CD. When you search for CDs at a brokerage, make sure you select the "not callable" option on the search.
Buy Newly Issued Brokered CDs To Avoid Commissions
Newly issued brokered CDs can be bought without paying a commission fee. However, most brokerages will charge you a commission if you buy an older CD on the secondary market or if you want to sell a CD you own. Brokered CDs are not liquid, which means that if you need to sell before your CD matures you will have a tough time finding a buyer. You will have to list it on the secondary market through your broker's bond interface. Usually you must and lower the price you ask to where that price makes the yield of the CD much higher than that of competing new offerings or treasuries, and where it takes into account the commission the buyer must pay to buy your brokered CD. Even when you set a low price you may have trouble finding a buyer. So don't buy brokered CDs unless you are sure you can hold them until they mature.
The Only Early Withdrawal Available for a Brokered CD is the Death Put
Most brokered CDs come with a Death Put, which means that upon your death your heirs can claim the principal before the CD matures without paying a penalty. Some brokerages won't manage this for you and that your heirs will have to contact the issuing bank directly to exercise this right. Check with your brokerage to find out their policy and notify your heirs when you write up your instructions for them.
If the issuing bank fails, the FDIC will return your invested principal and interest accrued to the date when the bank failed to the brokerage which should distribute it to you within a short time, based on the experience of those who have had this happen .
Remember that the limit of FDIC insurance for a single bank applies to the total you have invested in that institution under the same account name. So don't hold more than $250,000's worth of brokered CDs in any one bank or in a bank where you have other accounts outside of your brokerage. If your brokerage has a sweep account that invests in various banks, make sure you know how much is already invested in any bank whose CD you are considering buying.
Direct Bank and Credit Union CDs
You can buy a CD from a local bank or credit union by walking into their local office. But nowadays you can also buy CDs from banks and credit unions all over the U.S. online. My experience with local banks has been that the rates available from the better online banks and credit unions are far better than ones offered locally. I've also learned it takes far more time and paperwork to open and close a CD in person at a local bank than it does to buy one from one of the larger online banks or credit unions with an established online presence.
I always check depositaccounts.com to find the best CD rate offerings for my region. Then I check the health report that the site provides for any bank I'm interested in which draws on the latest quarterly FDIC report to give you information about the institutions financial health. Finally, I read the reviews posted to rule out those that customers report as being hard to deal with. Quite a few are.
Note that many banks and credit unions do a soft or hard pull on your credit report. You may be rejected when you apply if you have frozen your credit reports.
A Bank or Credit Union Early Withdrawal Penalty is A Big Advantage When Rates Are Low But A Problem at Today's Rates
Banks and credit unions both local and online will usually let you close a CD before it matures if you pay the early withdrawal penalty stated in their terms. This is far easier than selling a brokered CD. But make sure you know what that penalty is before you buy. They can range from just a few months' worth of interest to all the interest you were paid and a small amount of the money you invested.
When rates were near 2%, early withdrawal penalties were trivial--often only half a year's interest, which might only be 1%. So you could pay the penalty and still come out ahead when you reinvested in a CD yielding 3.5% or more. But now that rates are nearing 5%, this is no longer true, as you need a much higher rate to compensate for the 2% - 5% penalty you would pay on today's CDs. Many banks are also imposing far more onerous early withdrawal penalties than were common just a year ago. So research your bank's penalties before buying and only buy CDs you expect to be able to hold to maturity.
Ally bank offers no penalty CDs which allow you to break your CD at any time during its life. These often pay better rates than savings accounts and money market funds. I have had several over the years and have never had a problem with them.
The amount of the early withdrawal penalty you pay when redeeming a CD invested in a taxable account can be deducted from you income when you file taxes. Some banks or credit unions will allow you to withdraw money from a CD in an IRA before it matures if you must pay a required minimum distribution. Check with the bank or credit union about whether they allow this before you buy a CD in these institutions.
How to Avoid Limits on ACH Transfers In or Out of a Bank or Credit Union
Limits on incoming and outgoing transfers: Though many banks and credit unions limit how much you can transfer in or out of your account in a single day or month via bank-initiated ACH (electronic transfer between financial institutions) they don't limit how much you can pull from the bank or Credit Union if you initiate the transfer from your brokerage. Link your account at the brokerage and you can pull large amounts with no problem. Schwab limits individual transfers to $100,000 but there is no limit on how many such transfers you can set up in a single day.
Some credit unions will not show you the actual account number for your share account, the savings account your matured CD's proceeds go into. A message or call to customer service will get you the correct number.
How to Extend the $250K/Account Limit on FDIC and NCUA Insurance
The FDIC (bank insurance) and NCUA (credit union insurance) only insures accounts of $250,000 of less, except in the recent and unusual case of Silicon Valley Bank where it insured all accounts. However, you can extend the amount you invest in a bank or credit union by adding "Payable on Death" (POD) beneficiaries to your account. These are the people or, in some cases, charities, who would inherit your account if you died while the CD was active. However, as long as you are alive, they have no claim on the account.
Not all institutions permit POD accounts, but many do. Adding POD beneficiaries to an account can usually be done online at those who allow them.
The FDIC's calculator telling you how much insurance you actually have at a bank where you have POD accounts or other kinds of accounts registered under different names, like an IRA account or a joint account with a spouse, can be found here: https://edie.fdic.gov/calculator.html . Note that as of April 1, 2024 the rules for FDIC coverage will change and limit the insurance provided for POD trusts to a total of $1,250,000 per account.
The NCUA calculator that insures credit union accounts can be found here: Insurance Estimator .
For further details see:
Grab These 4.5% Fixed Income Yields Before They Are Gone