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CDs vs. Bond Funds

I recently finished reading Allan Roth’s How a Second Grader Beats Wall Street. (Highly recommend it, by the way.)

In the book, Roth brings up a topic that I’m surprised isn’t discussed more frequently: the idea that if you’re willing to put in the time, you can very likely increase the long-term return on the fixed income portion of your portfolio without increasing your risk at all.

How? By shopping around for CDs rates rather than investing in bond funds.

Why would CDs earn more?

The limit on FDIC insurance for CDs is set at $100,000 (temporarily increased to $250,000). This amount–while more than enough for most individual investors–is practically meaningless for the large institutional investors who make up the bulk of market demand for investments.

As a result, if institutional investors want something backed directly by the Federal government, they have to invest in Treasury bonds or bills. Therefore, the demand for CDs of a given maturity is lower than the demand for Treasury investments of the same maturity, despite the fact that–if you stay under the FDIC limits–they both have essentially zero risk of default.

Lower relative demand for CDs means that they must provide a greater rate of return.

CD Rates: An Inefficient Market

Also, because of the lack of institutional demand for CDs, the market for CDs is far less efficient than other security markets. What does that mean for you? It means that if you spend the time to shop around, you’re likely to find that certain banks are offering significantly higher CD rates than other banks.

Further, if you make sure to compare early withdrawal penalties while doing your CD shopping, you can limit your interest rate risk considerably.

Is it worth your time?

The downside to this strategy, of course, is that all this CD shopping takes time (more than simply DCA’ing into a low-cost bond index fund).

Whether it’s worth your time is largely impacted by the size of the fixed-income portion of your portfolio. For example, I doubt I’ll be spending my time on it, as my wife and I have a very equity-heavy allocation given our young age. But I could easily see it making sense for us a while down the road.

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  1. You can increase your chances of finding higher CD rates by looking at different types of CDs as well. Jim at Bargaineering recently wrote a post about different kinds of CDs (callable, brokerage, etc.) that offer higher rates of return than the plain vanilla kind. However, you have to be careful of these. Some of them may not be FDIC insured.

  2. Great post, I had never thought of CD’s as a worthwhile alternative to bonds, but the logic you put forth makes a lot of sense, or is it cents? 😀

  3. Because of the additional time necessary to research different types of CD’s & their rates, I will be sticking with the bond index funds. Thank you for the information, it grows my confidence in the investment decisions I have been making recently.

  4. Rick Francis says

    Mike- the one problem I can see with using CDs over bonds- taxes! You can get bond funds in any tax sheltered account but can you put money in an IRA or 401K in a CD? If not the returns on the CDs will be taxed as income. Unless the CD rates are a LOT better wouldn’t tax sheltered bond funds win out?

    -Rick Francis

  5. OI,

    I’d love to see the numbers because I find it hard to believe that CDs effectively pay more than MuniBonds. I am from NY so I looked up Vanguard’s NY Long Term Muni Bond fund (VNYTX) – As of 6/24 it is yeilding 3.82%.

    On Bankrate there seems to be rates from 2%ish (1 year) to 4% on 5 year…but these are pre tax so effectively we are talking 1.75 to 3.5%ish WITHOUT LIQUIDITY vs. the liquidity found in a bond fund.


  6. Miranda: Thanks for bringing that up. (For anybody who missed it, the post she’s referencing can be found here: )

    Rick: Good point regarding CDs in a 401k–unlikely to be an option. But yes, you can certainly get CDs in an IRA. Not necessarily the IRA you have now though…

    That is, you might have to go to a bank, open an IRA with them, and buy a CD in that IRA. So, as I mentioned above, a bit of a pain!

  7. My Journey: Two thoughts. First, as mentioned, the CD market is probably among the least efficient securities markets around. I’d think that this would mean that there could be times when the situation Roth describes does not, in fact, hold true.

    Second thought: Your comparison isn’t exactly apples to apples, so to speak. Specifically, there’s a big difference in duration. According to Morningstar, VNYTX has an average effective duration of 7.28 years.

    Also, while muni bonds obviously have a low default rate, they’re not backed by the Federal gov. Theoretically, this should increase yield somewhat.

    Finally, you’re looking at a state muni bond fund. For the most part, these only appeal to investors in that state. Again, lower demand = higher return. (That said, when the muni fund’s yield is high enough–as appears to be the case from your quoted example–it should still attract out of state investors simply due to its federal tax free status.)

  8. Given that institutional investors are supposed to be the savviest and most well-informed investor class, shouldn’t their absence from a market make it worse for the consumer rather than better? If banks know that they are selling predominantly to the uninformed individual investor, it seems that they would price CD’s at bel0w market value knowing that they could get away with it. Just because a market is inefficient does not automatically make it beneficial. What sort of evidence is there that CD’s present the superior values postulated by the author?

  9. Jacob: I’d agree that inefficiencies don’t necessary benefit the investor.

    I’d still argue that there’s something to be said for a lack of competing purchasers.

    A quick glance at the current interest rates for Treasury securities as compared to CDs of a similar maturity gives some evidence that Roth’s argument isn’t too crazy.

  10. I think the point being made in the article is a good one.

    I don’t find the argument that CDs pay so well because the market for them is “inefficient” to be convincing. If the other markets were efficient and CDs were paying better, the smart players in those other markets would move in and “exploit” the better deals available in CDs.


  11. OI,

    You are 100% Correct I am not comparing apples to apples.
    1) I should have mentioned that Munis are not backed by the federal government. However, I would love to see what would happen if Cali defaults – if GM is too big to fail, what is Cali?

    2) I live in NY, a high tax state – I should have made note of that.

    Notwithstanding the above, the increased liquidity and effective higher return of a Muni Fund makes it seem like a better choice in most instances.

  12. Okay, I’m a little biased because CDs is what we do. MyJourney, one other point is duration. MuniBonds typically have longer maturities than CDs. So while the rate is higher, the investor has to be prepared to tie up the funds for that period of time. Also, depending on the market it may cost you more to sell your Muni than it would to close your CD. Of course if you purchased your Muni a few years back, it has probably swung the other way.

    Although, many corporations don’t invest heavily in CDs, public entities do. With treasuries at their current levels, Entities like Cities, school districts, etc are investing heavily into CDs. So besides Fed Funds keeping CD rates low, the flood of cash from them is also keeping the rates low.

    I don’t believe the CD market is inefficient because there are programs such as CDARS and custodial CD programs that make the management and investment of CDs quite painless. Institutional investors that have their investment options limited are able to invest upwards of $40MM into CDs and the systems are quite efficient.

    cd :O)

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