Nominal interest rates are dismally low.
As of Aug. 1, the iShares 7-10 Year Treasury Bond ETF (IEF | A-55) was yielding 1.28% with a 7.620-year duration. With the power of compounding, your money will double in only 54.5 years!
Of course, you could chase income, such as with the so-called safe master limited partnerships, but high and safe income is an illusion, as illustrated by the Alerian MLP ETF (AMLP), which lost 25.7% last year.
Let me counter that depressing lead-in by suggesting a better way. Consider buying brokered certificates of deposit in the secondary market, by which I mean buying an existing CD from someone else through brokerage firms like Fidelity, Vanguard and Schwab.
These CDS Trade Like Bonds
A key difference between these CDs and the ones you buy from banks is that brokered CDs trade like bonds, if you need to sell before maturity.
If interest rates in the marketplace have fallen, you may receive a higher price than you paid for the CD. But if interest rates rise, you are likely to receive less than you paid. These CDs look and act like bonds.
For example, on Aug. 3, Fidelity was offering a Synchrony Bank CD on the secondary market yielding 2.41% and maturing on April 10, 2025, or roughly in 8.7 years. The duration was 7.60 years, just under the iShares IEF fund.
Once the commission is taken into account, the CD yields 2.40%. The CD is noncallable, meaning the bank can’t decide to cancel the CD and pay your money back early.
Benefits & Downsides
The benefit of this strategy over Treasurys is obvious—a net yield of 2.40% versus 1.28% while taking on no more interest-rate risk, since they both have the same durations. However, there are three downsides.
First, if you live in a state that has state income tax, the Treasury interest is state tax-free, while CD interest isn’t.
Second, the entire CD may not be FDIC insured, as only the par value is FDIC insured. Because rates have declined, nearly all of the CDs are trading at a premium. So in the Synchrony Bank example, the CD could be bought at $103.383, but if Synchrony went belly up immediately after you bought it, you’d only get back 96.73% of your principal (100/103.383). Over time, the uninsured portion will shrink.
Finally, if you have to sell a CD before maturity, there are typically higher bid/ask spreads than with Treasurys, though the data isn’t readily available.
Here are five tips to consider if you pursue a brokered-CD strategy:
- Stick to a reputable broker. Depositaccounts.com offers some valuable advice on buying secondary CDs.
- Don’t buy a callable CD. If rates stay low or fall even more, the issuer might call the bonds. That means you won’t likely get that attractive yield for long.
- Make sure you don’t need your principal back before the CD matures. As noted, you could get paid less than you paid if interest rates rise. In addition, you will pay a commission and a spread if you later sell your CD in the secondary market.
- Don’t let the interest payments accumulate in cash. Brokered CDs don’t allow you to reinvest interest in the same CD, and many brokerage firms still pay you a whopping 0.01% annual yield on your cash.
- Never go above FDIC insurance limits, which are $250,000 for an individual account and $500,000 for joint accounts per bank. By titling accounts correctly, however, it’s easy to get much more FDIC insurance.
In my view, earning 2.40% interest that is nearly all U.S. government backed is far superior to settling for the 1.28% Treasury return. It at least gives a likelihood of besting inflation.
Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine.