Investment Strategies: Why We Aren’t Loading Up on CDs

The Allure and Pitfalls of Certificates of Deposit (CDs) 
In my last presentation, I quickly reviewed a slide explaining why short CDs have historically underperformed the rest of the bond market in the 12 months following the end of a Fed rate raising cycle.  But the question of whether we should be cashing everything in to buy 5% CDs keeps coming up (along with the dividend question we covered the other day) so I wanted to address it in more detail.   

In this 6-minute video I explain why we generally believe abandoning your long-term strategy to buy CDs is a bad idea.   

For those that prefer text to video, below is a summary: 

When we look back at the past 40 years of federal rate raising cycles, we see that a broad-based bond portfolio has historically outperformed short-term CDs. This result is primarily due to the longer average maturity of the broad-based bond portfolio and, to a lesser extent, credit spreads.  

To understand why the average maturity is so important, we first need to understand the relationship between bonds prices and interest rates.  When interest rates go down, bond prices go up. 

For example, consider a 10-year Treasury bond. If you own $1,000 of a bond paying 5% interest ($50 per year) and the market rates drop to 4% ($40 per year), your bond goes up in value by roughly 10%. This is because your bond will pay $500 cumulatively over the next 10 years whereas the newly issued bonds will only pay $400. The person that pays $1,100 to acquire the 5% bond will lose $100 when the bond matures but that loss is offset by the extra $100 they make in interest along the way.   

In the context of this discussion, that means if rates begin to move lower - which they tend to do in the 12 months following the final rate raise by the Fed - CDs underperform for two reasons: 1) they don’t get the near term price appreciation of longer bonds and 2) when the short CDs mature, you are forced to roll the cash into new positions paying the new, lower rates. 

BUT THIS IS AN ELECTION YEAR AND THE MARKET IS EXTRA RISKY!?!?!? 

How you manage risk is all about how you define risk. If you define risk as the change in price from one day to the next, the asset with the most stable price (a short CD) seems the safest.  However, if you define risk as the likelihood of generating sufficient returns to maintain your spending power over the course of a multi-decade retirement, short-CDs begin to lose their appeal.  All investing requires risk. The trick is figuring out which ones you are willing to take.