It's Not As Bad As You Think

  |     |   1,374 posts since 2011

Aside from all the whining and moaning over low interest rates on CDs, when you run the math, it's really not all that bad. For example, would you rather get 50 basis points over inflation on your renewal CD when inflation was running 3%, or when inflation was running 2%? After-tax CDs, of course, we'd all prefer lower inflation, lower interest payments, and thus lower taxes. Now, shift to bond funds. Would you rather have a CD locked at 1.65%* for four years, or a short-term investment-grade bond fund yielding (currently) a tad more, but with an SEC yield the same, and the risk it would lose principal value should rates go up, not to mention the vagaries of credit-risk? The CD wins, hands down.

 Alan Roth has explained the reasons CDs out-perform bonds and bond funds, but it comes down to two things: taxes (or the lack thereof, on credit unions) and FDIC/NCUA insurance. Credit unions are non-profits.  Credit unions (and banks, for that matter), get a federal back-stop called FDIC/NCUA insurance. Courtesy of the US of A. Bonds, bond funds, forget about it. You want that type of protection, buy Treasurys (at a much lower rate). Combine the two "bests" and you get a CD from a credit union. Which readers of this blog already knew.

Stated another way, if you have a CD ladder (as I do, and you should), your renewing CDs should (thanks to this site) have yields equal to or better than inflation (i.e., a "real return"). The key is to have a long ladder (minimum five years, seven is better). Tax-advantaged (IRA CDs) are better than after-tax, as you avoid the tax friction on compounding. But even with after-tax, you are basically treading water quite handily, even after paying the federal and state tax. You lose a tad, but the peace of mind is (or should be) worth it.

Remember, as inflation goes up, so do interest rates. The reason interest rates go up, duh, is because inflation goes up. Think lock-step. Remember the early 1980's. Folks who ask the Fed to allow the Fed Funds rate to float up are basically asking the Fed to increase its target inflation rate, which is great for borrowers, but not so great for savers.  Think Greece, or Spain. Inflate your way out of the debt morass, and all that.

Bottom line: Be mindful of the "bottom line". It is often better to have the same spread (50 basis points) at a lower inflation rate than a higher rate, even though it might "feel better" to be making 5% on your CDs than 2.4%. Fixed-income is an anchor to your retirement portfolio. Take risk on the equity side. Buy long NCUA-insured CDs and ladder.


Just my $.02

*It gets a bit arcane, but folks over at Bogleheads (calculating TIPS yields and other stuff beyond my expertise) think forward-looking inflation to be below 2%. Thus, this horridly-low 1.65% 4-year CD from Alliant might not be that shabby. It's not that much better than the ten-year Treasury, but four years as opposed to ten? No brainer.

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