For many years’ the USA (and much of the developed world) offered very low interest rates on accounts with low risk (guaranteed accounts). The policy was known as “ZIRP” or “zero interest rate policy”.
As a result of ZIRP, this author started exploring CD’s purchased through a brokerage, which offered a couple of percentage points more in return (than zero) with the same, virtually zero risk. These brokerage account CD’s typically offered higher returns than you can get from your local bank or savings accounts.
Over the last couple of years, however, the USA has begun to raise interest rates. Today, the VMFXX money market from Vanguard offers a return of 1.74% (with an expense ratio of 0.11%). There is also an expectation of continued increases in the future, although no one knows for certain what will occur.
Since the “base” rate is now effectively about 1.75% (more or less), the CD forward “curve” looks like this:
- Base rate (no CD, leave in money market) – 1.75%
- 1 year CD – 2.30%
- 2 year CD – 2.80%
- 3 year CD – 3.00%
- 5 year CD – 3.30%
- 10 year CD – 3.40%
When you buy a CD, you essentially “lock up” your money for that duration. If you have a 2 year CD, for instance, you can always buy or sell off that CD, but if interest rates go up you won’t receive back 100% of your investment. For example, if you have a 2 year CD at a rate of 2.80%, and short-term interest rates move from 1.75% to 2.00%, for example, and you needed to sell your 2 year CD, you might receive 99 or 98 cents on the dollar (it could seem higher because you’d also be getting back interest accrued prior to your next payout, for example if you had a semi-annual payout). These are really minor “losses” in the grand scheme, especially if you are dealing in the thousands or even few hundreds of thousands.
The future of our interest rate policy is (as always), essentially unknown. Interest rate policy is also closely tied with the value of our currency, although this takes the entire conversation off into a far more complex direction.
In a time of ZIRP for an extended period (we had it from 2008 to 2015), buying products like CD’s was essentially the only way to get any sort of risk free return on interest at all. With short term interest rates at 1.75% and (likely?) heading upward, now there are more options on the table, including doing nothing and taking the short term rate or locking up funds for the near term or even medium term.
All of this income is taxable. Thus the effective rate that you receive is lower, depending on your tax rate. Tax rates did come down a bit with the 2017 tax changes, with most folks in the 12% / 22% / 24% range. Thus if you get 2% your return is effectively around 1.5% – 1.6% after taxes.
This blog will also look into the current state of iBonds, another product that is essentially risk free that we reviewed in the past, in an upcoming post.