When rates on CDs are higher than bonds, why invest in bonds at all? If most bond prices are negative so far this year, why not sell them and just deposit the money at the bank where we can earn a couple percent? Anything positive is better than something negative, right?
These are good questions and it's important to explore the answers since some (or many) of you have probably asked yourselves similar questions lately. The issue is that, so far this year, bond investments are mostly negative while yields on cash investments like CDs have turned up in recent months and seem more appealing.
Year-to-date, the total return (including dividends) of core bond index funds like Vanguard's Total Bond Market and iShares Core Aggregate Bond Index are down around 1% - 1.2% while 1yr CDs, for example, currently offer almost 2.5%.
It's entirely reasonable to consider dumping underperforming bonds in favor of nice, safe, comfortable CDs at the bank. The problem is that it's the wrong thing to do. Or, at least it's the wrong thing to do with your long-term savings.
A couple of weeks back we explored how to think about cash and where to consider stashing it. We talked about "cash-cash", which you want to keep in your checking and savings accounts. We talked about emergency fund cash, which is ideally suited for short-term investments like CDs. But when it comes to your portfolio, where your long-term investments reside, CDs and other short-term risk-free investments aren't really appropriate.
Why not? The answer gets back to something we discussed in that same post. You should have clear differentiation between what needs to be short-term money and what is available to invest for longer-term goals such as retirement, funding your child's college education, etc.
The issue with CDs is that they are primarily meant to safeguard your cash and not necessarily used to accumulate more. By design, CDs should just barely keep pace with inflation. For example, if you were to invest a lump sum of money into a 1yr CD and diligently roll it over at maturity year after year, you would have preserved most of your purchasing power but not have gained anything. This is fine in the short-term when we're less concerned about inflation, but not for the long-term when what you're trying to do is grow.
While the security CDs provide might be appealing, it comes with an opportunity cost. Even though core bonds are down so far this year, they are still expected to yield more than CDs over the long-term. How much more? Prepare to be underwhelmed: about 0.8%. Yes, that's all. But this adds up to real money over time and that's the main reason you want to favor bonds over CDs in your long-term accounts.
Here's a chart showing the return of cash investments like CDs (represented by T-Bills) versus the bond market year-to-date.
Cash is up while bonds are down, that's pretty straightforward. There's also no volatility, which is comforting when markets get whacky. But stretch things out a bit to see how bonds behaved over the last five years and you'll see how the higher return from bonds adds up.
If bond investors jumped ship to buy CDs, they'd be missing out on higher returns over time. Currently, the Vanguard fund I mentioned offers an SEC-yield (an estimation of the yield on bond funds at current prices if held for a year) of 3.1%, already higher than the 2.5% available on a 1yr CD.
You'll notice the dip during the first part of this year in the chart above. Bonds dropped (and so did stocks) on better-than-expected economic news and fears that interest rates would rise faster than anticipated (rising rates are bad for bonds). The Vanguard and iShares funds I referenced earlier declined by about 2.3% during the period and have been slowly inching their way back since. So, the rub is that to get the higher return on bonds you must be able to whether some down times, such as we're in now.
CDs and other risk-free investments are best used in short-term accounts where safety is critical, and you won't have enough time to recover from market volatility. You get what you get in terms of yield because that is (or, should be) a secondary concern. Core bonds, on the other hand, are best for longer-term accounts where you can afford to wait out the down times while being compensated over time for the added risk you're taking.
The answer to the CDs versus bonds question should be clear – you want both, just in the right places!
Have questions? Ask me. I can help.
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