The brokered CDs generally have higher rate than the bank direct CDs, for example, vanguard and fidelity currently have 4.5% 5-year brokered CDs. But The ONLY way to withdraw early the brokered CDs is to sell them at the secondary market, which is not liquid at all, i.e., may NOT be able to sell them. If the rate goes up significantly like the 70s, the 5 year CD can go up to 6.5% or even higher. If we can not sell the brokered CDs in the secondary market, then we get stuck with 4.5% for 5 years. I would rather pay 365 days EWP to go for the higher rate. I guess that's one of the serious disadvantages of the brokered CD in comparing to the bank direct CDs. Any thought, anyone?
Answers
The current situation we face is a bit atypical. And decisions might be different because of it. But unless you were unfortunate enough to have bought a CD early this year in which case the decision to liquidate is likely simple, at current interest rate levels it becomes more of a play on your assumptions going forward as the economics of prematurely closing a CD are typically onerous. Even if your 6.5% prediction possibility happens it matters just as much as to when it happens. If it happens next month then the direct CD might’ve been the better bet, but if it’s in 2 years I suspect the brokered CD results in a better outcome…again admitting I am assuming a liquid and cheap market to sell into. And as you state you were also earning a higher coupon on the brokered CD while you held it, so further compensation to mitigate potential sale inefficiencies.
And as a side note, I will eat my soiled shorts if US rates get to 6.5%! I would love for it to happen. But no one who borrows/pays interest is situated to be able to pay it. Not consumers, not homeowners, not corporations, and not Uncle Sam. We’re likely within mere weeks/months of something catastrophic breaking….it always does. It’s actually starting already (and that’s with what would have been traditionally described as an ultra accommodative policy as rates are STILL considerably below the rate of inflation)
Of course nobody has crystal balls to know how high the fed funds rate will go, I personally think the terminal rate will be north of 5%, the rate has to be higher than the core inflation in order to fight the inflation. So if the overnight rate is 5%+, the 5 year CD rate can very well be 6.5%+. As you discussed in detail, depends on how high the rate goes and lots of other variables, whether it is economical to break and move to a higher rate CD remains the question. Now, if the rate goes down, one still need to pay EWP to break the CD if he/she needs the money earlier for some reason. But for treasuries, one can easily sell them at a PROFIT instead of paying the penalty. So again, whether the 0.5% interest difference is worthwhile.
Let's add in the corporate bonds. A JP Morgan Chase bond matures on 10/01/2027, exactly 5 years from today, traded at around 5.8%. Much more liquid than the brokered CD, but less liquid than the treasuries. I highly doubt that JP Morgan Chase bond will default in 5 years. It is the largest US bank by asset size, if it goes bankrupt, FDIC will probably goes bankrupt as well, maybe the uncle Sam as well.
Now, here comes the multiple choice question, which of the following 4 investment vehicles will you buy and why, everyone who read this post please voice your opinion. All these 4 investment vehicles are available to purchase today.
A. 5 year treasury @ 4%, highly liquid
B. 5 year bank direct CD @ 4.25%, with 365 day EWP.
C. 5 year brokered CD @ 4.5%, illiquid
D. 5 year JP Morgan Chase bond @ 5.8%, moderate liquidity.
Everyone who read this post, please vote your choice and explain the reasoning.
AND YOU GOT IT REVERSED! When one pay $94 to buy that bond, he/she realizes the difference between the YTM 5.7% and coupon rate 4.25% RIGHT AWAY, that's why he/she is only paying $94, not the par value $100. The gains are FRONT LOADED! Probably you never bought any bonds before, that's why the confusion.
On your second point, you are wrong. When you pay $94 to buy a bond you don't realize the entire difference until the bonds mature and you receive all the bond proceeds at a par value of $100. The only thing that happens when you pay $94 for the bond is that it increases your current yield from 4.25% to 4.46%.
I have bought many bonds over the years.
So the current yield for choice A is 4%. choice B is 4.25%, choice C is 4.5%, choice D is 4.46% (if you calculated correctly, I did not double check). Same 5 year term, the choice D is still almost the highest (0.04% difference from choice C IF you calculated correctly), why "Here's the problem"?
If I had to make a choice now, I would try to find a 4.25% direct CD with a 6-month EWP. Don't know if that exists, however. I would like to see the coupon rate and yield for JP Morgan Chase 3-yr bond. I might be willing to wait 3 yrs as opposed to 5 yrs for the additional yield over the coupon rate.
here's another article comparing direct vs. brokered CDs that might be of interest:
https://www.bankrate.com/banking/cds/what-are-brokered-cds/
The highest bid was still below par @ 98.99. Still, it's inaccurate to say that one is stuck when buying a brokered CD. In fact, i would even argue that the EWP when factored in, could potentially be much more than selling a brokered CD on the secondary market. I am seeing 365 days of interest+ on many of these 5 year CDs. Using 100k at 4% as an example that would come out to $4,000 penalty to get out of a bank cd with a 1 year EWP. If the same CD was brokered, the broker would have to offer $96 or less per unit which is highly unlikely unless you've locked in a super low rate and rates do sky rocket.
Now, if someone bought the same capital one CD several months earlier, at 3.5% coupon rate, now this CD is worth roughly $95. If this person sells this CD now, he/she will lose MORE THAN the 365 day EWP (3.5%), and he/she is lucky because this brokered CD is liquid.