Locked up in CDs? Consider Short-Duration Flexibility
In this video, Portfolio Managers Jason England and Nick Maroutsos discuss why investors may be attracted to Certificates of Deposit, or CDs, given their recent rise in yields. They make the case that for conservative investors looking to maximize their return potential as well as their flexibility, CDs in this current environment may be a limiting investment vehicle.
- The national average for CDs ranges from 0.7% for one year to about 1.3% for five years, which are historical lows, as well as below the fed funds rate and the current 3-month T-Bill.
- One of the large drawbacks to CDs is concentration of risk.
Jason England: Certificates of Deposits, or CDs, may be attractive to conservative investors seeking insurance from the FDIC.
There are several drawbacks to CDs: limited liquidity, most CDs have lock-ins of six months to five years, and you incur penalties or lost interest for early withdrawal. Also, low yields – the bank rates quotes right now that the national average for CDs ranges from 0.7% for one year to about 1.3% for five years, which is below the fed funds rate and the current 3-month T-Bill. There’s also lack of inflation protection. The return potential or rates on most CDs right now is lower than the inflation rate.
Nick Maroutsos: We believe that there are significant advantages of focusing on short-duration income strategies, particularly in this current environment. There are three issues that we believe that are facing fixed income investors and that is policy normalization, the threat of inflationary pressures and rising interest rates. Many would view these as negatives, but we actually view those as positives, because now what you’re doing is you’re creating a situation where the positive advantages of carry are really attracting investors back into fixed income. If you think back to where we were three, four, five years ago, we were investing in an environment where interest rates were 2% to 3%. Now that the Fed has started to normalize policy, those rates are significantly higher and offer investors much better rates for their short-term investments.
I think the critical component here is where you’re investing, because all investments aren’t created equal. The front end offers significant value compared to the longer end of the curve, because the curve is so flat. When you look at the interest rate differential between the 2-year part of the curve and the 10-year part of the curve, there’s only 35 basis points that separate those two securities. If the duration component for those securities is quite large, the interest rate sensitivity of a 10-year bond is significantly greater than that of a 2-year bond, so for example, when you look at the 2-year bond, it would take roughly about 150 basis points of sell-off to negate the yield on the 2-year bond, because it has a relatively short duration, whereas a 10-year bond, it would only take about 30 to 35 basis points of sell-off to negate the entire yield of a 10-year bond. While the front end offers opportunities, it is critical to focus on the right area of the curve for your investments. We also believe that that means looking at the entire global landscape. It doesn’t mean just focusing on domestic issues or corporates just in the U.S.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Bank products such as certificates of deposit may be insured or guaranteed by the Federal Deposit Insurance Corporation or another government agency, an investment in securities is not.
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Carry is a measure of excess income generated
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
CD yield: Source: Bankrate.com as of 11/1/18
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