Buying CD’s Through a Brokerage Account

As part of my “basic investing plan“, this site describes how to buy CD’s through your brokerage account.

Buying CD’s through your brokerage is the same as buying them through your bank, except that you typically receive a much higher interest rate. When a bank sets up a CD or savings account and markets it to their existing customers, they typically pay their existing customers much lower than the highest rate available in the market.

Since CD’s are completely interchangeable, you can buy a CD from any bank. If the bank is taken over by the FDIC (Federal Deposit Insurance Corporation), you receive your money back plus accrued interest. During the last financial crisis many of my CD’s were redeemed by the FDIC in this manner.

You can select CD’s from the highest yielding bank. As long as the bank is insured by the FDIC and you are not past your insurance limit for that bank (typically $250k, although this can be higher if you look at joint minimums), you are completely insured by the Federal government and there is no risk of default as long as this program exists.

Here are the current yields for new issue CD’s. They will vary slightly but give a good idea of what you can receive over the next 5 years for no risk. New issues are bought at “par” or 100% of value.

CD yields

11/8/22 2.4% (5 years)

11/8/21 2.15% (4 years)

11/9/20 2% (3 years)

11/12/19 1.75% (2 years)

11/18 1.5% (1 year)

In these instances I am recommending “new issue” CD’s because if you buy an existing issue then it gets more complex. You will buy at some price other than 100% of par depending on interest rates and time outstanding and then you will potentially have gains or losses when or if you sell or hold to maturity. Since the differences are slight and the complexity is unneeded, I typically recommend buying new issues only.

If you need to sell the CD to raise cash for a purchase, you can sell them through the brokerage platform. You will receive a slightly higher or lower price depending on current interest rates vs. interest rates at the time you bought the CD. You will also receive a different amount based on accrued interest (because the purchaser will receive the payment, not you).

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Portfolio Two Updated August 2017

Portfolio Two is our second longest lived portfolio.  This portfolio has been converted to ETF’s and a CD.  Beneficiary investment is $6500, trustee investment is $13,000 for a total of $19,500.  Current value is $34,290 for a gain of $14,790 or 76%, which is 7.8% over the life of the fund annualized.  Go here or to the link on the right for the portfolio detail.

This portfolio is different from the others in that there is a 1.55% CD for $10,000 and the rest are ETF’s.  The largest ETF is VTI (US total index) with VEU (all world ex US) and HEFA (non US, hedged).  We also have a small position in IBB for biotech.  All seem to be doing well.

It is a symptom of ZIRP that our CD returns less than the US or European stock funds, which are around 2.5% / year.

Portfolio 2 Updated April 2017

Portfolio Two is 12 1/2 years old.  The beneficiary contributed $6500 and the trustee $13,000 for a total of $19,500.  The current value is $33,334 for a gain of $13,834 which is 71% or 7.4% / year when adjusted for the timing of cash flows.  You can see the portfolio detail here or go to the links on the right.

This portfolio is different than the other portfolios because it has shifted to ETF’s and CD’s.  The ETF’s are broadly tied to the US and non-US stock indexes.  There is also a CD that returns 1.55% / year for $10,000 in the portfolio.

Since markets have gone up over the last year, this portfolio has done well (it tracks the market).  All of the ETF’s are near 100% of their 52 week high, which means that they are at or near their highs and the indexes have been rising continually over this time period.

Unlike the other portfolios, which are invested in individual stocks, these ETF’s do have annual expenses.  You can’t “see” the expenses because you receive the returns “net” of expenses, but this is disclosed.  Over the 1 1/2 years that we’ve had this portfolio the low cost ETF’s cost $86, which is very low for a portfolio of over $30k.  If you go back ten or fifteen years ago mutual funds would routinely cost 2% or more each year which would be $600 / year on a portfolio of this size.  It is a testament to the efficiency of ETF’s (which drove competition in the mutual fund markets, mutual fund expenses have been driven down proportionally, as well) that these sorts of rock bottom expenses are now commonplace if you know where to look.

In a technical note, the CD does fluctuate in value (a bit), but I record it at cost ($10,000) since we intend to hold it to maturity.  The cost fluctuations thus do not matter.

Finally, in another note, when I moved this portfolio over to Google Sheets, I noticed that I had been overstating the contributions in the “cash flows” calculation since 2012.  Thus the recorded return since inception now looks higher.  The value of the fund was always correct it was just the calculation of total gains to date that was incorrect.

 

Portfolio Two Updated January 2017 – Tax Time

Portfolio 2 is our second longest lived fund, at over 14 years.  This fund has transitioned from individual stocks to an ETF and CD mix.  The beneficiary contributed $7000 and the trustee $14,000 for a total of $21,000.  The current value is $32,151 for a gain of $11,151 at 53% or about 5.5% / year when adjusted for the timing of cash flows.  You can see the spreadsheet supporting this at the link on the right or download it here.

The fund contains 4 ETF’s and one CD.  The $10,000 CD earns 1.55% and will redeem in July, 2018.  This investment is essentially risk free (if the issuer goes under the FDIC will pay out the accrued interest and return the principal).

The largest ETF is VTI, which covers the US stock market on a capital weighted basis (that is to say that the largest market capitalization stocks comprise a larger portion of the index).  Since we have had a rally in Technology (prior to the election) and financials and commodities (mostly since the election), this ETF has done well.

There are two non-US ETF’s, the VEU (all world non-US, unhedged) and HEFA (major non-US markets, hedged against the dollar).  Surprisingly, these two funds mostly performed alike in terms of returns, even though the dollar rose during this period.  This is something I will investigate further in the future when I have some more time.

The fourth ETF is IBB, a NASDAQ bi0technology ETF.  This one was kind of a bet on future growth since it had been pummeled in the period before we purchased it.

In general, these ETF’s are low expense and overall the portfolio has a decent yield at 1.9% comprised of dividends and interest on the 1.55% CD.  This is a nice cash addition in an era of zero yields on short term cash and when even some large issuances have negative yields over a ten year span (in Europe).

I noted that the ETF HEFA (the hedged fund) had a small capital gain.  This is rare for ETF’s (they are common for mutual funds).  Since it is immaterial it is listed as a dividend on the report.

Due to the fact that these trust funds are “subsidiaries” of my account, typically they don’t pay any fees on transactions for individual stocks (essentially zero expenses every year).  Since ETF’s do have expenses, this portfolio will incur implicit expenses (they come out of the returns of the ETF’s so you don’t see them directly).  About $70 in implicit expenses hit the portfolio during 2016 (the CD is free of all expenses).

On Investing

Investing has changed significantly during the 25 or so years that I have been following both the market and also the tools available for an investor to participate within the market.  The following trends are key:

  • The cost of trading and investing has declined significantly.  Trades used to cost more than $25 and now are essentially free in many cases.  Mutual funds used to have “loads” of 5% or more standard when you made an investment, meaning that $100 invested only went to work for you as $95.  These sorts of up-front costs have almost totally been eliminated
  • ETF’s have (mostly) replaced mutual funds.  ETF’s “trade like stocks”, meaning that you can buy and sell anytime (mutual funds traded once a day, after being priced with that days’ activity) and they don’t have income tax gains and losses unless you actually make a trade (mutual funds often had gains due to changes in the portfolio that you had to pay taxes on even if you were just holding the fund)
  • CD’s and Government Debt are all electronic.  You used to have to go to a bank for various governmental bond products or to buy a CD.  Now you not only can buy all of this online, you can choose from myriad banks instantly rather than settle for whatever your main bank (Chase, Wells Fargo, etc…) offers up to you
  • Interest Rates are Near Zero.  One of the key concepts in investing is “compound interest”, where interest is re-invested and even small, continuous investments held for a long time can end up amounting to large sums (in nominal terms, because inflation often eats away at “real” returns).  However, with interest rates basically near zero, you need to earn dividend income or take on more risk (i.e. “junk bonds”) in order to receive any sort of interest income.  There is no “safe” way to earn income any more
  • Currency Fluctuations Matter.  When the Euro initially came out it was $1.30 for each US dollar, and then it went to 70 cents per dollar, and now it is about $1.10 per dollar.  At one point the dollar fell 30-40% against many currencies world wide (when “commodity” currencies like the Canadian and Australian dollar were surging).   For many years currencies were relatively stable against one another but that era seems to be ending, and thus the change in relationship between the US dollar and their currency can be much greater than the return that is earned on the international investments
  • Active Trading Has Mostly Been Beaten By Passive Trading.  While there are many exceptions, initially the majority of investments were “active”, but over the years many of the “active” managers have substantially under-performed the market, wilst charging investors more in fees (it is cheaper to run a “passive” index).  As a result, there has been a massive shift away from active investors to passive investors like Vanguard
  • Correlation Among Stocks and Investment Classes Is Much Higher.  Correlation means that stocks or asset classes tend to “move up” together or “move down” together.  It is not unusual for me to look at a portfolio of 20 stocks and 19 or 20 of them have all gone up or down on a single day.  This is related to active managers being unable to “beat” the market (see above)
  • The “Risk Premium” for Lower Quality Debt is Small.  The amount of extra interest required for low quality borrowers over the US Treasury benchmark is very small.  Investors are taking on a lot of risk to just earn a few more percentage points of return.  If there is a downturn in the economy (such as what happened only recently in US oil companies), there are likely to be significant declines in junk bond values that wouldn’t justify the modest risk premium you receive for holding these types of assets
  • ETF’s Provide an Easy Way to Participate in Commodity Markets.  It was more difficult to buy and invest in commodities like gold and crude in the past, and it was often limited to relatively sophisticated investors or those willing to hold on to physical commodities like gold (which can be risky since they need to be stored and protected due to high value and inability to trace once stolen).  Today you can easily buy a liquid ETF to participate in the commodity markets for key areas like precious metals (gold and silver) and crude oil / natural gas
  • Fewer Companies are Going Public and the Market is Shrinking (in terms of issuers, not total value) – It is easy for start up companies to access private capital (venture funds) and they tend to “go IPO” at high values, making a further upside (after the initial IPO) more difficult.  The total market is shrinking in terms of listings due to M&A (companies buying other companies) faster than the new IPO’s and many companies are “buying back” shares which also reduces the total value of the public markets
  • Bonds have had a Gigantic Bull Market that is Nearing It’s End – Bond prices move inversely to yield; thus if you held on to a 5% low risk bond (which would have been available everywhere in the early 2000’s), that bond would currently be priced at much more than 100 cents on the dollar today.  Interest rates peaked around 20% near 1980 and now are not far from zero; in this sense bonds are part of an enormous “bubble market” that has not yet peaked.  But given how low rates are (they are even negative), it seems like this bull run is about to come to an end
  • Ensure That You Include Dividends and Total Return.  A common mistake is to look at performance just in terms of stock or asset prices, and avoid including the compounding impact of dividends received, especially since dividends often rise each year.  Dividend income can make up a significant portion (25% and up) of total return, so selecting assets that provide dividend income is critical.  Finally, dividends provide favorable tax rates when compared to interest income

What does all of this mean?  I would sum it up in two ways:

  1. It is easy for individual investors to set up a simple and low cost way to track the market – the “basic plan” that I set up as a simple example can be used by anyone and it does what it says.  Here is a second plan that also includes some hedging of the non-US investment
  2. You will need to save much more (or take on more risk) because interest rates are low – with near zero interest rates, you can’t make much money on low risk interest bearing products (like CD’s, savings accounts, and simple government debt).  If you are earning risk income, you likely are taking on substantial risk of default because there is no “free lunch”.  As a result, you need to put more cash into stocks in order to earn dividends or see real returns, but this also could lead to significant losses if there is a market crash like 2008-9.

I try to promote financial literacy and have helped many friends and some family members when they ask questions.  Ideally we would actually drive financial literacy through school and into the university.  Even those who have a degree in finance or accounting often lack practical advice on personal finance and don’t know how to approach these issues.

One key concept is “net worth”.  Net worth isn’t how much you earn in salary, it is what remains in savings after taxes (or through long term deferral of taxes).  The only “assets” that count are those that you can turn into cash if needed, and they are “net” of the debt (such as on your house).  Most people have a negative or near-zero net worth, which is also linked to the concept that they are essentially a couple of missed paychecks away from very bad outcomes such as having to take out a payday loan or borrow money from relatives.

Another key concept is trying to avoid excessive student debt.  Unlike all other forms of debt (loans on your house, your car, or credit card debt) your student debt cannot be discharged through bankruptcy.  You essentially have no options except to repay your loans, and if you miss payments or fall behind the fees and penalties will greatly increase your balance due.  Student financial literacy is critical because they are making decisions that will impact themselves and their families for the rest of their lives and they must be made thoughtfully and with the end in mind (if you are taking out all of this debt, you must be driven in your career to make money in order to pay it off and get on with building net worth).

Cross posted at Chicago Boyz

Portfolio Two Updated March 2016 – Tax Time

Portfolio Two is our second longest lived portfolio, at 11 1/2 years old.  The beneficiary contributed $6500 and the trustee $13,000 for a total of $19,500.  The current value is $27,814 for a gain of $8,314 or 43%, for a rate of return of 5.2% adjusted for the timing of cash flows.  You can see the detail here or on the link on the right side of the page.

Portfolio Two is now unlike all the other portfolios.  Our goal is to have about 1/3 of the value in interest rate products (CD’s), about 1/3 in US stocks (VTI) and 1/3 in international stocks (VEU and HEFA).  This portfolio will invest only in CD’s and ETF’s going forward.  This is similar to the “basic investing plan” listed on the site header.

In 2015 we sold all the individual stocks in the portfolio, for a net long term gain of approximately $7300.  In the past, figuring out the cost basis for your stocks was difficult but today the brokerage firm put the cost basis on each of the sales along with the trade date (to determine whether it is a short or long term trade) which makes it easy to calculate (if a little bit tedious, unless you can download your brokerage account directly to your tax software).  It depends on how it comes out but we are hoping that this goes under the tax rate at 15% or about $1100 but it will depend on the net calculation and other earnings of the beneficiary and the parent.