Money & Policy

Bank CDs or Bonds for Your Retirement Portfolio?

With the Fed raising rates, the question is especially timely

Yesterday, the Federal Reserve Board raised its benchmark short-term interest rate by 0.25 percent; additional rate hikes are expected later this year and next year. This news may have you thinking about buying bank certificates of deposit (CDs) or bonds for your retirement portfolio, to take advantage of the higher rates. Which is best for you?

CDs and bonds can generate income and reduce risk for your portfolio. This is especially important during retirement when a large investment loss could reduce income and increase the odds of outliving your savings. When deciding whether to purchase CDs or bonds, you need to consider the different types of investment risks.

Credit Risk and Your Retirement Portfolio

One advantage of CDs over many types of bonds is the lack of credit risk.

All corporate bonds have a risk that the company issuing them will not be able to repay the debt. If that happens, the bondholder can lose principal (the bond’s face value). For high-quality corporate bonds (known as investment grade), the risk is small, but it is far from negligible.

According to a white paper published by Assets Dedication, the cumulative historical default rate from 1970 to 2006 for investment grade corporate bonds as reported by Standard & Poor’s was 4.14 percent. The risk from non-investment grade corporate bonds was 10 times higher.

Municipal bonds also have credit risk, with the possibility of the municipality declaring bankruptcy. The risk has generally been lower than corporate bond default, but it’s not zero.

That Asset Dedication white paper found a cumulative historical default rate from 1970 to 2006 for investment grade municipal bonds to be 0.20 percent as reported by Standard & Poor’s. The risk from non-investment grade municipal bonds was 36 times higher.

The one type of bond that does not have credit risk is a Treasury security, because it’s issued and backed by the federal government.

Bank CDs do not have credit risk, as long as the depositor stays below the federal insurance coverage limits ($250,000 per depositor, per FDIC-insured bank, per ownership category). For all deposits up to these limits, the federal deposit insurance providers (FDIC for banks and NCUA for credit unions) guarantee the principal and accrued interest up to the day of failure of the financial institution. Both the FDIC and NCUA insurance are backed by the full faith and credit of the United States government.

Interest Rate Risk

While not all bonds have credit risk, all bonds have interest rate risk. When interest rates rise — as they have been and are likely to continue for the foreseeable future — the value of bonds fall. The lower value of the bond comes into play if you need your money before the bond matures. To get the cash, you must sell the bond, and that can result in a loss.

CDs bought purchased directly from banks or credit unions do not have interest rate risk. You lock in a rate when you buy the CD. These CDs are different than brokered CDs issued by banks but sold through brokerage firms. With those CDs, if you need your funds before the CDs mature, they must be sold much like bonds, so they have similar interest rate risks.

Most direct CDs, however, have an early withdrawal penalty which must be paid if you withdraw principal before maturity. The early withdrawal penalty is typically not tied to interest rates. In general, CDs with longer terms have larger early withdrawal penalties. The size of the penalty is generally described as a certain number of days or months of interest paid by the CD.

In a DepositAccounts.com study of early withdrawal penalties at more than 2,000 banks and credit unions, the average early withdrawal penalty for one-year CDs (which now pay about 2.2 percent) equaled 119 days of interest. For 5-year CDs (which now pay about 2.7 percent), the average penalty was 242 days of interest.

If interest rates rise substantially after you buy a direct CD, the early withdrawal penalty remains fixed. For bonds, the more interest rates rise, the larger the loss that would occur when the bond is sold before maturity. Since the penalty is fixed, a direct CD holder may find it profitable to redeem a CD early and redeploy the money into a new higher-rate CD when interest rates rise substantially.

Bonds have an advantage over direct CDs when interest rates fall, though. In a falling-rate environment, bond values rise and the bondholder can profit by selling a bond before maturity.

Comparing Yields

There have been times when rate-leading CDs had a substantial yield advantage over Treasury securities with similar maturities. This was especially true when the Fed held short-term rates near zero — from 2008 to 2015.

As the Fed has increased rates recently, Treasury bills and notes have become more competitive with CDs. These days, a five-year Treasury note yields around 2.90 percent and a rate-leading CD with the same maturity yields 3.25 percent.

Convenience and Yield Shopping

Another important consideration is convenience. A common type of retirement account is an Individual Retirement Account or IRA, which can hold all types of investment products including bonds and CDs.

Even if you only want risk-free investments such as CDs, you’ll sacrifice yield if you only maintain one IRA at one bank or credit union. CD investors can get much higher rates by yield-shopping and regularly moving money to new CDs at different banks and credit unions.

However, transferring IRAs between banks and credit unions can be difficult, requiring significant paperwork and phone calls. If mistakes are made, you could be hit with Internal Revenue Service penalties.

In a brokerage IRA, you can easily shop for yield on bonds and other low-risk investments without moving money to other IRAs at different institutions. This can be more convenient than yield shopping for IRA CDs at banks and credit unions.

It’s Not All or Nothing

When deciding between bonds and CDs inside retirement accounts, it doesn’t have to be all or nothing. You might want to own bonds and CDs. Although interest rates are rising, rates are likely to remain at historically low levels for years. So it behooves you to consider all options allowing you to earn as much as you can on your low-risk investments.

By Ken Tumin
Ken Tumin is the founder and editor of DepositAccounts.com.

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