Treasuries vs. Certificates of Deposit

PURCHASING CD’S THROUGH YOUR BROKERAGE ACCOUNT

Recently I wrote a post about how CD’s can be purchased through your brokerage account (Fidelity, Schwab, Vanguard, etc…) and how easy that it is to do so.

Recently I built a “ladder” by taking the amount that I wanted to invest and breaking it into 4 equal groups and buying CD’s as follows:

one year interest rate 2.75%
two year interest rate 3.95%
three year interest rate 3.9%
four year interest rate 4.1%

I called my brokerage account and they read the rates & banks over the phone and I was able to make these purchases in about 15 minutes. The process is simple because they only offer FDIC insured CD’s, so there really isn’t much to differentiate each issue except for the frequency of payments (my 1 year CD paid out at maturity, the rest pay out either semi-annually or monthly, as I noted in my other article all things being equal the more pay outs you get each year, the higher the “real” return).

These CD’s are very easy to administer because they were purchased at face value (no discount or premium) and when the interest payments are made they will just show up in my brokerage account rather than compounding with the CD, which makes taxes (a bit) more complex later.

The reason I built a ladder is because I am not smart enough to “guess” the yield curve and which way interest rates are going. As each component of the ladder matures (i.e. a year from now), I will repurchase a CD at the “far” end of the maturity level. For instance a year from now my 1 year CD paying 2.75% will mature and at that time I will buy a 4 year CD at prevailing rates (which could be higher or lower than the 4.1% I received today).

CD’S VS. TREASURIES

Recently Treasuries have been in the news since the yield on government debt has fallen to extremely low levels. This article describes the situation:

“Due to stampeding demand for safe short-term investments, the US Treasury’s four-week and three-month bills on Friday yielded an effective rate of 0.01 percent — down sharply from 1.515 percent and 1.785 percent, respectively, in early September… the 10-year bond yield fell as low as 2.505 percent and the 30-year bond yield slid to 3.005 percent at one point on Friday. The six-month bond yielded a mere 0.20 percent. The low yields reflect a surge in demand for these instruments, seen as the safest in the world during times of turmoil. Analysts say the fear factor has pushed up demand for Treasuries, since investors are virtually certain the US government will not default. The panic in global financial markets has sparked an unprecedented rush into safe US Treasury securities, driving yields on short-term government notes down to almost zero…”

To an individual investor, Treasuries and CD’s insured by the FDIC should be viewed roughly as equal in terms of risk. It would have to be near “end of days” when the US Government defaulted on Treasuries, but the situation would have to be almost equally as dire when the government would consider letting FDIC insured bank deposits fail.

For large investors, CD’s aren’t really a substitute for Treasuries because of the limits on government insurance coverage and the comparatively il-liquidity of the CD market. Large investors, who are demanding access to low risk places to put their cash, are driving down the yields on Treasuries as noted above. The ten year bond per above is around 2.5% and presumably 2-4 year yields would be closer to 2%, so you are almost doubling your rate of return on CD’s vs. Treasuries.

For smaller investors it is pretty clear that you are better off with brokerage CD’s than with US Treasury securities for money that you wish to have some return and as close to zero risk as possible.

If you are interested in more information about FDIC insurance here is the official FDIC site and here is a link to Treasury Direct where individuals can purchase US government securities.

Cross posted at LITGM

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