I first learned about certificates of deposit (CDs) two months ago through a few posts on different stock boards on Yahoo Finance. Most of these posts went like this: "I'm pulling out some of my money and parking it in bonds and CDs." Since then, I have noticed a few CD advertisements in the US, one from my small bank (credit union) a week ago, another from a small bank I just walked past, and some other ads online, but those probably reflect my search items.

Has this anything to do with the rising federal funds rate? Does it have any significance at all? Most importantly, do you suggest putting some of my cash into CDs instead of treasuries and highly-rated bonds?

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    Do you buy T-bills directly from Treasury Direct? Do you directly buy bonds? Or do you buy t-bill and bond funds? – RonJohn Aug 12 '18 at 1:56
  • @RonJohn Yup, you guessed it right. I buy bond ETFs. – ToniAz Aug 12 '18 at 2:32
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    Bond funds are pretty lousy investments since they have lower yields than equity funds (on average), but still don't have the return of principal at maturity that actual bonds have. – Glen Pierce Aug 12 '18 at 4:39
  • @GlenPierce According to what I know, bonds (and by association bond funds) are not meant to produce a higher yield than equities, but they are meant to be safer investments. It is true that you will get your principle back on a bond. In a similar way, you can sell your bond ETF shares. – ToniAz Aug 12 '18 at 13:01
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    I don't have any problem with bonds. They have their place in certain portfolios. It's the bond funds that give up both principal protection and yield. – Glen Pierce Aug 12 '18 at 13:59

Short term CDs (like 3 months) are tied to the Fed Funds rate. Longer term CD's (like 5 years) are tied to longer term interest rates.

Bonds and Treasuries perform inversely with interest rates. As rates go up, your principal declines but at maturity, they will be worth face value, aka par. A CD's value is constant. In both cases, your money is tied up until maturity.

I wouldn't presume to give you advice as to what you should do, more so because in general, I'm not a long term fixed income type. In a slowly increasing rate environment, it makes no sense to me to do a 2 year CD for 2.60% or a 3 year CD for 2.70% when I can get ~2.00% in a money market account. Perhaps an exception to this is a variable annuity where I removed a chunk of money from equity exposure in January just before the market headed south and it is collecting 3% in the cash account while being fully available at any time. But that's a more complex story.

For income, I hold a number of investment grade preferred stocks which on average are paying about 6%. You can get higher a yield than that but the quality starts to drops off. Sometimes these react temporarily to short term rate changes. They are primarily tied to long term rates since the call dates for new issues tends to be 5 years out. I frequently swap them if I can nab 1/3 to 1/2 of a quarterly dividend in a few days or weeks. That bumps up the yield nicely. When we had an interest rate cycle (more than 10 years ago), you could double or triple the yield, depending on the amplitude of the rate cycle in a year. This might be something for you to learn about for the future.

  • Thank you again, Bob. Indeed, there is a LOT to learn from you and the rest of the pros on here. I heard many bad things about preferreds, so it's a bit of a shocker to know that you're investing in them. I wanted to buy the CCI preferred for a 6.875% yield ($60) a while back, but I decided to put my stock proceedings into a cash account, or perhaps a T-Bill or a CD. The 2/10 yield spread is 20 BPs as a Friday, so I want to act quick. – ToniAz Aug 13 '18 at 13:51
  • Hi Toni. What bad things have you heard about preferred stocks? The CCI "A" issue is a Mandatory Convertible Preferred Stock and that's a very different beast than traditional preferred stocks. It's also trading above par so you won't get the full yield of the coupon (6.875%) and the various conversion terms make my head hurt. – Bob Baerker Aug 13 '18 at 14:04
  • My understanding is based on Ben Graham's "The Intelligent Investor" and some YT videos. Here are some of the negative things that I've heard: (1) It's riskier than a bond (since its holders get paid only after bondholders get paid) and its upward potential is less than that of the common; i.e. it has the worst of both worlds (some people would say it has the best of 2), (2) it's terms are confusing and only suited for very experienced investors, even two mandatory convertible preferreds could be different, (3) I forgot about the rest and I have to go back – ToniAz Aug 13 '18 at 15:08
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    Risk and reward go hand in hand. Bonds are safer than Pfds and Pfds are safer than the common hence the increasing reward potential of each. Investing has risk. Pick your tolerable level of poison! For traditional Pfds, there are two issues (1) Quality of the issuer and (2) Long term rates. AFAIC, a convertible is a bet on the future price of the common so it's a specialty category. Though not infallible, the best source of Pfd info other than the prospectus is QuantumOnline. – Bob Baerker Aug 13 '18 at 15:44
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    @ToniAz - A good book on this topic is: PREFERRED STOCK INVESTING - Fifth Edition by Doug K. Le Du. If not available at the library, it’s around $20 new but you can pick occasionally pick up a 4th edition for under $10. I learned some interesting things from it despite having owned and traded preferred stocks for 20 years or so. My only disagreement with his approach was with his selling parameters. – Bob Baerker Sep 10 '18 at 13:58

In times of rising rates, bond ETF values drop. The longer the average term of bonds in the fund, the steeper the drop. It's counteracted by reinvested dividends.

CDs (and directly purchased bonds and t-bills) aren't like that. You buy it, and they doesn't lose it's value. Thus, that's where you put money you don't want to see evaporate during a market downturn like 2007/08: if those funds have dropped 30% right when you need the money, you're hosed.

(They're also FDIC insured.)

For someone who lives off of a salary instead of interest/dividends, CDs are medium term savings, not a long term investment.

  • But the value of these funds is determined by the value of the bonds they own, right? If the bonds they own are stable, why would the funds go down? (bond funds indeed lost 30% like you said in 2008-9). This must be because they did not buy their bonds directly from the treasury? – ToniAz Aug 12 '18 at 13:19
  • @ToniAz the market value of a bond is governed by (at least) two criteria: #1 demand (mostly in the negative sense, like "I need to sell whatever the price because I need cash now", or "I think the company is going to default"), and #2 interest rates (if the face value interest rate of a nominally $100 bond is 5%, but the prevailing interest rate is 3%, then the hypothetical market price of the bond is $101.94, since $101.94 * 1.03 = $100 * 1.05). – RonJohn Aug 12 '18 at 13:47
  • @ToniAz thus, when it's 2008 and you desperately need cash, you sell your bond (or shares in a bond fund) for less than it's "mathematical worth" because you really need some cash. – RonJohn Aug 12 '18 at 13:50
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    @ToniAz and if rates are rising, then the value of your bond drops. For example, if you bought a 5% bond when the market rate is 5%, you paid $100 for it. But now the market rate is 8%. Thus, your bond is now worth -- on the open market -- $97.22 because $97.22 * 1.08 = $100 * 1.05. – RonJohn Aug 12 '18 at 13:55
  • Thank you. I didn't understand your example as I'm only starting to get into fixed income, so I follow this up in a new post :) – ToniAz Aug 13 '18 at 13:45

Certificates of deposit are offers by banks to give higher rates of interest for longer-term deposits. In times of rising interest rates banks want you to lock in your interest rate (usually below or slightly above the FED funds rate) for long terms so that they can lock in interest rates that are lower than the expected future interest rates. This gives them cheap borrowing in the future and stabilizes their deposits.

Essentially at best, its an okay deal for you (depending on your situation) and a great deal for the bank. You are right that rising interest rates have something to do with the uptick in adverts. You lock in a rate that you will have to pay a penalty to get a better increased and they get cheap borrowing.

I would pay off debt before paying into a CD. Right now Goldman Sachs offers 3% for 5-year deposits which is currently one of the best rates today. Treasuries are around 2% and but buying bond or treasury funds will decrease in present value as interest rates increase, better to buy the bonds directly. Consider short-term bond funds or buying treasuries directly if you want bonds.

  • "but buying bond or treasury funds will decrease in present value as interest rates increase." Why is that? Is it because the coupons of the bonds held in these funds is low, while coupons of newly-issued treasuries ought to much the federal funds rate which is higher? – ToniAz Aug 12 '18 at 13:11
  • A bond is issued at $1,000 and pays 5%. If interest rates rise to 6%, who would be willing to pay $1,000 for a 5% yield? The price of the 5% bond must be discounted to provide a 6% return, hence the reason that as rates rise, bond values drop. – Bob Baerker Aug 13 '18 at 19:34

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