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.

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.

What To Do With Maturing CDs?

I started buying 5-year CDs directly from banks and credit unions ("direct CDs") about five years ago, because I learned about the advantages in terms of risk and expected return compared to bonds or bond funds. Perhaps you did too, either based on my musings or those of bloggers from whom I learned about direct CDs, like Allan Roth and The Finance Buff. Now that our CDs are starting to mature, what should we do?

Northwest FCU 3-year 3.04% Add-On CD

Today someone asked a question on the Bogleheads forum about saving for a house down payment in 3-5 years from now, so as part of answering the question, I checked the 3-year CD rates at DepositAccounts.com. I was flabbergasted to see a rate of 3.04% APY at the top of the list (with the closest competition at 1.85%). This is a promotional CD special ("Dream Fund Certificate") offered by Northwest Federal Credit Union (NWFCU), with a minimum deposit of $10,000 and maximum of $100,000. After finishing up my answer to the forum question, I quickly investigated the CD deal, then proceeded to complete the online application to join the credit union, open an account, and buy this CD. It took about 15 minutes.

The Value of an Investment Policy

If you've paid any attention to financial markets lately, days like today and weeks like this week provide examples of the value of establishing and following an Investment Policy (IP). Among other things, an IP establishes your target asset allocation and rebalancing policy. So when stocks drop much, all you do is check your current asset allocation to determine if your rebalancing policy requires shifting some money from fixed income (CDs, bonds, cash) to stocks.

Consumption Smoothing and Adjusting Your Frugality Setting

Consumption smoothing is the economic concept used to express the desire of people to have a stable path of consumption throughout their lifetimes. The ideal consumption smoothing case, assuming no bequest motives, is to save just enough during your working years to be able to spend your retirement savings to fund about same lifestyle in your retirement years, and to die broke. Of course since we don't know how long we'll live, or exactly what our expenses will be in retirement, this is a difficult ideal to achieve.

To give yourself a reasonable margin of safety for retirement, you may need to be more frugal in your accumulation years than you want to be. Conversely, if your investment returns were better than expected, or perhaps you were just more frugal than you had to be while working and saving, it might be reasonable to be less frugal in your retirement years than you disciplined yourself to be in your accumulation years. Your consumption smoothing may not end up being ideal, but perhaps it then makes sense to work on overcoming your previously virtuous frugality, and spending more to enjoy your remaining years more.

USAlliance Financial 2-year CD, 2.27% APY

Today I became a member of USAlliance Financial credit union, and opened a new 2-year CD with an APY of 2.27%. This is an incredible rate on a 2-year CD, with most of the 2-year CD competition in the 1.5% ballpark, and the 2-year Treasury yield at about 0.7%. This 2-year rate is even a bit better than the 5-year CD rate at Synchrony Bank (2.25% APY). This premium rate is available only to new members, and is a limited-time offer, with a maximum deposit of $100,000. I haven't paid much attention to laddering CDs, because generally I can earn a better return doing early withdrawals from longer-term CDs, than by holding shorter-term CDs in a ladder. But this CD is an exception to the rule, and provides a nice 2-year rung in a CD ladder.

First bank-to-bank IRA transfer from a maturing IRA CD

I recently completed my first transfer from a maturing IRA CD into a new IRA CD at another bank, and everything went very smoothly. There are two reasons I would consider doing such a transfer: 1) better rates at another bank or credit union; 2) stay within FDIC/NCUA insurance limits. Both were applicable in this case. If neither was a factor, I would have just rolled the maturing CD into a new CD at the current bank. Unless you own any IRA CDs, and you may eventually want to transfer the balance to another bank or credit union when they mature, there is no need to continue reading; there are no other investment lessons here.

Human Capital, Financial Capital

The value of a young person's future earned income typically is much larger than the value of her savings and investments. In economics jargon, her human capital is much larger than her financial capital. Conversely, an older person has much less human capital and hopefully much more financial capital. Human capital is converted to financial capital by working and saving over the years. A higher savings rate converts more human capital to financial capital. The ratio of human capital to financial capital is an important consideration in determining ability to take risk in one's investment portfolio.

Synchrony Bank 5-Year CD

Note: Since originally publishing this, GE Capital Retail Bank has been renamed to Synchrony Bank, and the 5-year CD rate now is 2.25% instead of 2.30%. I have re-titled the post accordingly and done a few minor edits since I refer to this blog post so often in my Bogleheads posts.

I am in the process of transferring out of some bond funds and a money market fund in my IRA at Fidelity to a new IRA CD at GE Capital Retail Bank (GECRB, now Synchrony Bank). The CD interest rate is 2.30% APY (now 2.25%), and the early withdrawal penalty is six months of interest. This is an excellent fixed-income choice in today's ongoing-low-rate environment. PenFed credit union offered a much better deal back in December 2013 and January 2014, with a 5-year CD earning 3.03%, but nothing has come close to that since. Top CD rates have been hovering around 2.25% lately. Following are some details about what I've done so far to open the account and transfer the funds, and a recap of why I like CDs purchased directly from banks and credit unions.

Market Update

Financial markets have been relatively calm so far in 2014: US stocks have gained about 1-2%, total international stocks are up almost 3%, and total return on US bonds has been about 3.5% (I'm using returns from Vanguard's Total Stock Market Index, Total International Stock Index, and Total Bond Market Index funds). There was a mild correction in late January with US stocks down about 5% and international stocks down about 7%, but other than that, stocks have been mostly bouncing around the +/-2% range.

By contrast, 2013 was a big up year for stocks and a down year for bonds. US stocks returned more than 30%, international stocks returned about 15%, and the Total Bond Market index fund lost about 2%. US stocks got an extra boost from small-cap stocks which returned about 38% in 2013. International stocks were dragged down by emerging markets which lost about 5% in 2013, while developed international markets gained about 22%. Bond fund losses, caused by generally rising interest rates, were proportional to interest-rate risk (average maturity/duration of fund), with Vanguard's Inflation-Protected Securities fund losing almost 9% and its Long-Term Government Bond Index fund down about 12.5%.

Mountain America Credit Union 5-Year CD

It's sad to say, but these days finding a 5-year CD that earns even 2% is becoming difficult. Mountain America Credit Union (MACU) is one of the few credit unions or banks that currently offers a nationally available CD that earns 2.0% APY. Of course I learned about this CD from www.depositaccounts.com, which is my standard source for good CD deals. About 10 days ago I joined the credit union, opened an IRA account, and started the process of transferring money from two other IRA accounts into an MACU 5-year CD.

2012 IRA Contributions: Not Too Late

This is a reminder that you have until April 15 to make your IRA contributions for 2012. This could result in a lower 2012 tax bill if you make a deductible  contribution to a traditional IRA (TIRA), or lower future taxes if you make a contribution to a Roth IRA (Roth). While you're at it, go ahead and make your 2013 IRA contributions if you have the money. The rest of this post summarizes your options and my thoughts on what makes the most sense.

I Bought a Barclays 5-Year CD

I just opened an account at Barclays online bank, and bought a 5-year CD, which currently is one of the best CDs available nationally. It earns 1.85% APY with an early withdrawal penalty (EWP) of 90 days of interest. This makes it a better deal than Ally Bank's 5-year CD which currently earns about 1.6% APY with an EWP of 60 days of interest, or PenFed's 5-year CD earning 1.65% APY or their 7-year CD earning 1.75%, both with an EWP of 365 days of interest.

Barclays 5-year CD

One of the best CDs currently available for taxable accounts (IRA accounts are not available) is the Barclays 5-year CD, with an APY of 1.85% and an early withdrawal penalty (EWP) of 90 days of interest. See Ken Tumin's blog post CD Rate Hike at Barclays at DepositAccounts.com for details.

Stocks Are Up; I'm Rebalancing

You may have heard that stocks have been hitting five-year highs lately. When you hear this in US news sources, they usually are referring to the S&P 500 or the Dow Jones Industrial Average. Of these two, the S&P 500 is more representative of the broad US stock market, but it leaves out most smaller cap stocks.  Broader indexes that represent the total US stock market are up even more over the last five years. Given this strong performance, I have come close enough to my rebalancing band for stocks vs. fixed income that I have sold some of my US stock funds.

I'm Buying More I Bonds

Sometime toward the end of this month I will buy more I bonds for my personal and trust accounts at TreasuryDirect. The current annual rate is 1.76%, so I will earn half of that, or 0.88% for the first six months (January through June). The rate for each subsequent six month period depends on inflation as measured by the CPI-U. If inflation is 0% or less for the six months ending March 31, 2013, the rate for the second six months would be 0%, so I would earn a total of 0.88% over one year (actually a little more, since I'm buying toward the end of January, but will earn interest for the full month of January). Even this worst case scenario isn't bad, since I'm earning a little less than 1% in my online savings account. More importantly, I increase my allocation to super-safe, inflation-protected investments.

What About Europe?

It's old news that Europe has been having serious economic problems. How has this affected my investment strategy? The short answer is that it has not affected it at all. My investment strategy is not dependent on economic events. What has already happened is already reflected in stock prices. Current fears about what might happen also is already reflected in stock prices. Since I can't invest in the past, bad things that have already happened and have pushed stock prices lower have no impact on my investment strategy. Since I can't forecast the future (no one can), I have no special insight into what bad things may or may not happen, so I don't invest based on widely known information that causes many to fear that bad things will happen in the future (also already reflected in lower stock prices). This doesn't mean that I haven't made any changes in my portfolio as a result of the economic turmoil in Europe, concerns about slowing growth in China, etc. So what have I done and why?

PenFed Credit Card Deal

Hopefully you don’t have any high-interest-rate credit card debt that you don’t pay off every month, but if you do, you might be interested in the balance transfer deal currently being offered by PenFed Credit Union on all of its credit cards. There is no transfer fee, and you pay 4.99% APR for the life of the balances transferred by June 30, 2012. This seems better to me than the typical balance transfer deal where you pay a fee of 3% to 5% on the balance transferred, and then pay 0% on the balance for a limited time (typically one year, but perhaps up to 18 months).

One Goal, One Portfolio

“In which mutual funds should I invest in my new IRA?” This is typical of one type of question we get a lot on the Investing Help subforum of the  Bogleheads investment forum. The answer is: “we can’t advise you until you tell us about all of your investment accounts” (e.g., IRA, 401k, 403b, individual, etc.). This is because the decision to hold an investment in one account should not be made in isolation; it should be based on all investments related to a particular goal; e.g., retirement. It may make sense to design separate portfolios for separate goals, for example college expenses, a house down payment, and retirement, but there should be one portfolio for each investment goal, regardless of the number of accounts used. A portfolio is simply the collection of investments designated for a particular investment goal.