Saturday, October 31, 2015

CD 5-Year Report Card: Part 2 (Risk and Return)

In my previous blog post, CD 5-Year Report Card: Part 1, I compared the 5-year annualized return of a CD I bought about five years ago to the 5-year annualized return of a 5-year Treasury security (Treasury bond, or more formally, Treasury note) I could have bought on the same date. Although that's the most relevant comparison, it's not particularly interesting, since the annual percentage yield (APY) of the CD and the yield to maturity (YTM) of the Treasury basically predetermine the returns at time of purchase (assuming the CD or Treasury is held to maturity). 

(From now on, the term yield refers to yield to maturity (YTM) for a Treasury, other bond, or brokered CD (purchased through a broker), and it refers to the annual percentage yield (APY) for a direct CD (purchased directly from a bank or credit union). Also, the term return refers to annualized return).

In my next post, I'll review the 5-year returns for various bond funds, and compare them to the 5-year return of the CD. However, to evaluate these returns rationally, it's necessary to understand the relationship between risk and return for fixed-income securities, which is what I'll examine in this post.

Risk, return, yield

The expected return of an investment typically is related to to the risk of the investment; the higher the expected return, the higher the risk. In other words, for a higher risk investment, there is less certainty that the realized return will equal the expected return. Due to this greater uncertainty, investors demand a higher expected return for riskier investments.

So, investment risk is the uncertainty that an investment will earn its expected return over the time period of interest

There is very little uncertainty about whether or not a 5-year Treasury or 5-year federally-insured CD held to maturity will earn a return equal to its initial yield. Therefore, these investments are essentially risk-free over a 5-year holding period. 

Note that here I'm discussing risk in terms of nominal return, not real return. Real return is important, since it accounts for inflation, but in comparing various nominal fixed-income investments (as opposed to I Bonds or TIPS, which are real fixed-income investments), we can focus on nominal returns, since inflation affects all of these investments similarly.

For fixed-income investments, like bonds or bond funds, yield is an indicator of expected return, and higher yield typically means higher risk. Higher yield doesn't ensure a higher realized return, but investors demand a higher yield to compensate for the greater uncertainty that the fixed-income investment will earn the expected return.

Yield, risk and return for CDs

CDs are somewhat of an exception to the general relationship between yield or return and risk. For the last five years, good 5-year CDs generally have offered higher yields (and higher essentially risk-free returns) than 5-year Treasuries. 

The primary reason for this is that institutional investors (insurance companies, pension funds, mutual funds, etc.) cannot take advantage of the limited FDIC insurance; since institutions buy and sell hundreds of millions if not billions of dollars worth of fixed-income securities, the $250,000 federal insurance limit does not insure them against bank defaults

So CDs are not risk-free to institutional investors like they are to retail investors who can keep the amount of their deposits at a particular bank or credit union at or below the FDIC insurance limit. Therefore, institutional investors cannot arbitrage away the yield premiums of CDs over Treasuries.

A brokered 5-year CD (purchased from a broker) has about the same risk as a 5-year Treasury, since its price is determined by CD rates on the secondary CD market (where investors can buy and sell previously issued CDs). But a good direct CD (purchased directly from a bank or credit union) has less risk because of the early withdrawal option, which I explain in more detail below.

Two main types of risk for fixed income

A bond or bond fund has two primary types of risk:
  • Credit risk, also known as default risk
  • Interest-rate risk, also known as term risk
Credit risk (default risk) depends on the credit-worthiness of the institution that issues the bond or other fixed-income security being evaluated, and this is inversely related to the possibility that the institution will default on payments of interest or principal. 

The US government typically is regarded as one of the most credit-worthy institutions in the world (despite having it's credit rating downgraded from AAA to AA+ by Moody's in 2011). Therefore, US Treasury securities and federally-insured CDs have essentially no credit risk. Similarly, a Treasury bond fund has essentially no credit risk.

However, corporate bonds and bond funds that own them do have credit risk. A bond fund can hold just Treasuries, just corporate bonds, or a combination of both. The corporate bonds in a bond fund can be of various qualities, thus affecting the credit risk of the bond fund. The bond funds I'll examine in the next post span the credit quality range from high to low.

Interest-rate risk (term risk) is the risk that the value of a bond, CD or bond fund will decrease or increase due to an increase or decrease in the relevant interest rate or yield. Note that price moves in the opposite direction of yield or interest rate.

Even though the 5-year return of a 5-year Treasury held to maturity is essentially certain, the return over a shorter period is uncertain (e.g., if the bond were sold before maturity). If the yield of a 5-year Treasury were to increase from 2% to 3% shortly after purchase, the value of the Treasury would decrease by about 4.6%. If held to maturity, it still would earn its initial expected return of 2%, but someone who bought a 5-year Treasury after the rate increase would earn 3% over the five-year holding period. Being stuck earning 2% when the market rate increases to 3% is sometimes referred to as opportunity cost.

If the original owner sells the bond at a 4.6% loss to invest in a new 5-year bond with a 3% yield, the annualized return over five years still will be 2%, so there's no advantage in doing this. So the buyer of a 5-year bond with a 2% original yield will earn pretty much 2% over the five year term regardless of what is done.

Interest-rate risk is higher for longer terms to maturity, which is why it also is referred to as term risk. Therefore, bonds with longer terms to maturity will have larger price swings as interest rates change. 

For example, if the yield of a 10-year Treasury were to increase from 2% to 3% shortly after purchase, the value would decrease by about 9%--a much larger price change than the 4.6% change for the 5-year Treasury.

Since term risk is proportional to term to maturity, the term risk of a bond declines as it approaches maturity. The market price of a 3-year bond will decline less if the 3-year yield increases by 1% than will the price of a 5-year bond if the 5-year yield increases by 1%. After two years, a bond with an initial term to maturity of five years has three years left to maturity, and thus the price will change based on the change in 3-year yields.

All of the above also applies to a brokered CD. Since a brokered CD is a marketable fixed-income security (i.e., it can be bought and sold through a broker), its price is determined by market participants, and will be inversely related to prevailing yields for CDs of the same term to maturity. The annualized return of a brokered CD will equal its initial yield if held to maturity (ignoring reinvestment risk), but could earn more or less over a shorter time period (e.g., if sold before maturity).

Term risk of direct CDs

Things are different for a direct CD. The early withdrawal option of a good direct CD lowers the term risk significantly. If the 5-year CD rate were to increase from 2% to 3% immediately after purchase, an early withdrawal could be done from a direct CD at a cost of about 1% (assuming an early withdrawal penalty of six months of interest). Contrast this to the 4.6% price decrease of a 5-year Treasury or other bond.

So the direct CD owner has the possibility of earning an annualized return that is higher than the initial yield if CD rates were to increase enough, unlike the bond or brokered CD owner. This is the key advantage of direct CDs over brokered CDs.

Term risk of bond funds

The above discussion of term risk does not apply directly to a bond fund, because the typical bond fund has no maturity date. A bond fund is similar to a rolling bond ladder, in which bonds with a variety of maturities are purchased, and as each bond matures the proceeds are "rolled" into a new bond of the longest maturity in the ladder. Therefore, with a bond fund or rolling bond ladder, the term risk does not decline as time passes.

Note that this also is true for a rolling ladder of brokered CDs (purchased through a broker, instead of directly from a bank). Since there is no early withdrawal option for brokered CDs, they will decline in value just like Treasuries or other bonds if interest rates increase. 

Term risk of direct CDs vs. bond funds

Just as an individual direct CD has less term risk than a bond of the same maturity, a rolling ladder of good direct CDs has less term risk than a rolling ladder of bonds of the same maturities. The early withdrawal option of a good direct CD limits the downside term risk of each CD in the ladder to a relatively small fixed amount, so the CD ladder has correspondingly lower term risk. 

Since a bond fund is similar to a rolling bond ladder, a good direct CD generally has lower term risk than a bond fund. The longer the average maturity or duration of the bond fund, the higher the term risk compared to a good direct CD.

One caveat is that banks and credit unions often reserve the right to refuse early withdrawals, or to change the early withdrawal terms of existing CDs. In practice, this has hardly ever occurred, but some investors are concerned that it might be more common if interest rates were to increase a lot. However, I heard no reports of this happening when interest rates increased significantly in 2013, when the 5-year Treasury yield increased by 1.2 percentage points in about four months, from a low of 0.65% on 5/2/2013 to a high of 1.85% on 9/5/2013).

Direct CD ladder vs. direct 5-year CD

The low term risk of direct CDs is a reason to consider buying only 5-year direct CDs instead of constructing a 5-year ladder of direct CDs. A typical 5-year CD ladder would have CDs maturing in 1, 2, 3, 4 and 5 years. Since the term risk of a good direct 5-year CD already is so low, there's not much point in buying shorter-term CDs at lower yields to reduce term risk.

Aside from the risk of being denied an early withdrawal, you often come out ahead by doing an early withdrawal from a good 5-year direct CD rather than holding shorter-term CDs. 

For example, if you do an early withdrawal from a 5-year 2.25% CD with an early withdrawal penalty (EWP) of six months of interest, you earn an annualized return of 1.70%, which you can see using the early withdrawal calculator. This is a higher return than the the 1.5% annualized return that you'll earn on a good 2-year CDs (remember that the annualized return of a CD held to maturity is equal to the yield).

So you can think of a portfolio of good direct 5-year CDs as a 5-year CD ladder, but with higher average yield than an actual ladder. If you need the money for some reason before maturity, you can do an early withdrawal and probably earn more than you would from a maturing shorter-term CD. If you don't need the money before maturity, you end up earning even more than the 1-5 year ladder.

Next up

With these basics out of the way, we can proceed to rationally evaluate the return and risk of bond funds with all combinations of low, medium and high term risk, and low, medium and high credit risk, compared to the return and risk of a the direct CD. This is what I'll cover in my next blog post.

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