Monday, October 26, 2015

CD 5-Year Report Card: Part 1

Now that the 5-year CDs I bought about five years ago are maturing, I thought it would be interesting to compare the 5-year CD returns to the 5-year returns of some other fixed-income alternatives I could have invested in five years ago. All we should really have to do is compare the APY (Annual Percentage Yield) of the 5-year CD to the YTM (yield to maturity) of the 5-year Treasury at the time of purchase, since that's the most appropriate comparison in terms of risk and expected return for the forward-looking 5-year period. 

Looking at past returns raises the issue of hindsight bias, or as Larry Swedroe refers to it, confusing strategy with outcome. Nevertheless, people seem to have a hard time not using past returns to evaluate their investments, so I'll compare some of the more relevant returns in this and the next one or two blog posts.

The most common way to express returns is using average annual return, also referred to as annualized return or compound annual growth rate (CAGR). For a direct CD (purchased directly from a bank or credit union) in which interest is reinvested, the annualized return will exactly equal the annual percentage yield (APY), so we know in advance the annualized return just by looking at the APY.

Similarly, the annualized return of a typical Treasury security held to maturity will be approximately the yield to maturity (YTM) when the Treasury is purchased. This is not as precise a predictor as the APY of a CD, because the interest rate at which the Treasury interest is reinvested is not known in advance (reinvestment risk). However, at current low interest rates, this won't have a huge impact on the return, so I'll use the YTM of the Treasury as the annualized return.

The APY of the CD I purchased on September 15, 2010 (and that matured on September 15, 2015) was 2.74%, and this was the 5-year annualized return of the CD. The YTM of the 5-year Treasury on the date I bought the CD was 1.46%, which you can see in this table of Treasury rates provided by the US Department of the Treasury, and this was the annualized 5-year return of the Treasury. So we know that the average annual return of the CD was about 1.28% higher, since 2.74 - 1.46 = 1.28 (technically it is 1.28 percentage points or 128 basis points higher, but it is common to refer to it as a percentage, so I'll do that here).

Below is a tabular summary of what I've discussed above, but showing the annualized return of the 5-year Treasury compared to the 5-year CD (so it's a negative number; i.e., 1.46 - 2.74 = -1.28). This is the convention I'll be using in subsequent tables in this post and the subsequent 5-year report card posts.

Security or fundAverage annual returnCompared to CD
5-year CD2.74%
5-year Treasury1.46%-1.28%

Another way to express return is as a cumulative return, either in terms of percent or dollars; e.g., the growth of $10,000. With some simple bond math, we can calculate cumulative return from annualized return. For the 5-year CD and 5-year Treasury, the 5-year cumulative returns in percentage terms are 14.47% and 7.52% respectively--a difference of 6.96%. Growth of $10,000 is $11,447 for the CD and $10,752 for the Treasury--a difference of $696.

The table below shows these cumulative results.

Security or fundCumulative 5-year returnCompared to CDGrowth of $10KCompared to CD
5-year CD14.47%$11,447
5-year Treasury7.52%-6.96%$10,752-$696

So, as we knew would be the case, the 5-year CD provided a significantly higher 5-year return than the 5-year Treasury, regardless of how we measure it. 

Also, it's important to point out that the CD, which was a direct CD (purchased directly from a bank), provided the higher return with less risk. If interest rates had increased significantly, especially early in the term, I could have done an early withdrawal from the CD at a cost of only two months of interest, or about 0.5%, to reinvest at the higher rate. On the other hand, the Treasury could have experienced a much larger decline in value, proportional to the amount by which Treasury rates increased.

In the third post in this series, I'll review the 5-year returns of some bond funds that I might have invested in instead of the CD, including some bond funds that I did invest in in addition to the CD. However, for those results to make sense, it's necessary to understand the relationships between yieldexpected return, risk and realized return, which is what I'll examine in my next post.


  1. Shouldn't we consider Tax Bracket? If you are in the 39.6% federal and 6% NY or 13 % CA, would 5-yr Treasury come out even? Probably similar - splitting hairs?

    1. Good question, but the federal tax rate makes no difference, since both are taxed at federal level. Treasury is free of state tax. Let's say you do make $1M+/year, so are in the 13.3% CA tax bracket. Adjusting the CD rate for state tax only lowers CD rate to 2.74% * (1 - 13.3%) = 2.38%, which is still much better than the Treasury at 1.46%.