How To Beat Bond ETF Returns Without More Risk

March 30, 2017

Want to earn more without taking on more risk? Though I generally tell clients they can’t, when it comes to fixed income, they actually can.

First, I’m an advocate of bonds needing to be high quality. My advice to clients is to take their risk with equities and let their bonds be boring. I caution them against repeating the same mistake as in 2008 of trying to earn an extra 0.50% annually by taking on a ton of default risk. That’s why I like these high-quality low-cost intermediate-term ETFs:

Symbol Fund SEC
Yield
Duration Avg
Maturity
AGG iShares Core U.S. Aggregate Bond Index 2.40% 5.8 8.09
BND Vanguard Total Bond ETF 2.54% 6.0 8.20
IEF iShares 7-10 Year Treasury ETF 2.26% 7.6 8.37

 

The first two ETFs are roughly 64% U.S. government-backed (with the rest being investment-grade corporate), while the last is fully backed by the U.S. Treasury. The Treasury fund IEF yields a tad less, as all interest is state tax deductible if in a taxable account. All are intermediate-term.

But if you want more, consider buying brokered certificates of deposit in the secondary market. Below is a graph of all 1,753 noncallable FDIC-insured CDs that were available at Fidelity. Note the higher yields at comparable maturities, especially on the longer end.

 

 

 

Higher Returns Without Default Risk

So, you can see that you can earn an extra 0.30-0.50% annually with the same maturity. And compared to BND and AGG, you eliminate the default risk from corporate bonds. Don’t forget that GM was once investment grade before it defaulted.

Comparing the 10-year CDs paying as much as 3.0% to a 10-year Treasury yielding only 2.38% shows extra return, especially in a tax-deferred account, since there is no state tax benefit for Treasury interest.

Now, it’s true that you pick up a bit of liquidity risk with brokered CDs, because there is a higher cost of selling than with the ETFs. But that’s pretty minor, and I recommend holding until maturity anyway.

Tips For Buying Brokered CDs

  1. Stick to a reputable broker. DepositAccounts.com offers some valuable advice on buying secondary CDs.
  2. Don’t buy a callable CD. If rates stay low or fall even more, you won’t likely get that attractive yield for long.
  3. Make sure you don’t need your principal back before the CD matures. Just like any bond ETF, you could get paid less than you paid if interest rates have risen. In addition, you will pay a commission and a spread if you later sell your CD in the secondary market.
  4. 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 pay you a whopping 0.01% annual yield on your cash.
  5. Never go above FDIC insurance limits, which are $250,000 for an individual account and $500,000 for joint accounts per each bank. By titling accounts correctly, however, it’s easy to get much more FDIC insurance.
  6. You may have a little default risk if you buy the CD at a premium. For example, if you buy the CD at $102 and the bank goes under, you’d only be insured for about 98%. If you buy the CD at a discount and the bank is taken over by the Fed, you actually get back more.
  7. If you pay $1 per thousand in brokerage fees, this lowers your yield by about 0.01% annually.

Could this be that ever-elusive free lunch? I think so, and suspect the extra yield would be disintermediated away if institutions could benefit, but $250,000 FDIC insurance is rounding error for Goldman Sachs.

If you want more yield without more risk, consider brokered CDs along with your bond ETFs. And combining brokered and direct CDs gives you higher yields with inflation protection.

At the time of writing, the author owned none of the securities mentioned. 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. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter

 

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