Transition from Bonds to Certificate Deposits

Exploring the Advantages of Certificates of Deposit for Low-Risk Investors

Background:

Over the last 6 months, I have been increasing my exposure to short-term Treasury bonds (which mature in 12 months). The thesis was simple: these bonds were providing me with a healthy return of 5% without any risk (Figure 1). The risk free return was superior to any other money market or savings account. Since there was no way to know when the Fed would pause the interest rate hike, I kept buying tranches of these bonds at various yields. I started at 3.5% and bought my last (for now) at a yield of 5.2%. I wrote about it in my previous post, where I evaluated junk bonds vs. T-Bonds and persisted with T-Bonds.

Figure 1: YTD returns for 1 Year T-Bonds Yields Source: CNBC

Current Market Conditions:

The investment thesis was also supported by the overall market. As I explained in my previous post, there was a heavy inflow in T-Bonds and outflows from banking deposits. Another $126B was drained out of US banks just last week. Silicon Valley Bank collapsed due to dwindling deposits last month. A lot has changed since the collapse. The Fed is now dovish with the rate hikes resulting in a drop in yields for T-Bonds. As of today, 04/03, 12-month T-bonds are yielding 4.6% (Figure 2). I reminisce about the higher yields. In hindsight, I should have been more aggressive.

Figure 2: Yields on Fixed Income Source: TD Ameritrade

Investment Rationale and Constraints

With so much volatility in both the equity market and fixed income, one thing I want to avoid is investing in long-dated securities. There are multiple reasons:

First, these securities are susceptible to duration risk. Duration risk happens when an investor locks in the principal for a long duration (typically more than 1 year). The principal can significantly drop in value due if the interest rates go up, resulting in the loss of the initial capital (Figure 3). I explained the math behind this in one of my previous posts. This was the mistake Silicon Valley Bank made when they parked their money in long-dated mortgage-backed securities (more details here).

Figure 3: Bond prices go down when the interest rates go up

Second, locking my money would prevent me from investing in better opportunities in the future. Although, recessions are painful and ugly, they also level the playing field. It has been a dream to own a piece of real estate. As house prices become more affordable, I will try to find a good opportunity to diversify my portfolio.

Third, I am an active investor. Knowing that I will have to reinvest my capital in 12 months will keep me motivated and on the lookout. I will continue to upskill myself by learning about other financial vehicles to beat the overall market. For instance, I am currently reading Unconventional Success by David Swensen, where I am learning more about callable bonds. I will write about them in the future.

Fourth, I am a disciplined, value, active and conservative investor. Disciplined because I don’t gamble with my money. I treat is as prudent resource that exists to make more of it (I am sounding like Kevin O’Leary). Active and Value because I want to keep the control of my investments. I don’t just want to put money in S&P 500 without understanding the valuations. Although, there is nothing better than investing in S&P500 over the long term, I believe I can learn from mistakes. Conservative because I don’t take big bets. I remember back when Covid started, Delta Airlines bonds were yielding 20% within maturity in 11 months. I invested just $2K in spite of knowing I will never be able to match those returns probably in my life. That was the biggest mistake and learning for me as an investor.

Current Investment Options

All the above reasons limit my investment horizon. I can either invest in money market funds, keep my money in a savings account, buy short T-bonds or buy Certificate of Deposits (CDs), or invest in equities. Most of these options can easily give me a fixed return of 4.5%. Since my portfolio is heavily concentrated in US equities, I am actively trying to diversify this year. I won’t be putting more money into US equities.

More About CDs

It's no secret that banks are in constant need of deposits to sustain their operations and lending activities. CDs are a financial product that has been designed to lure those deposits back into banks by offering competitive interest rates. CDs are an excellent investment option for those looking to earn higher interest rates on a lump sum of money over a fixed period of time, while providing the added benefit of FDIC insurance to safeguard their funds.

Decision:

Personally, after conducting thorough research and analysis, I have found CDs to be a secure and attractive investment option. With their low risk and high yield, CDs are an excellent way to diversify my portfolio and earn a guaranteed return on my investment. I just opened a Marcus 10 month CD yielding 5.05%.

Risks:

CDs, like any investment, carry risk. While they offer stable fixed income, rates are locked until maturity. Inflation may lead to higher interest rates, reducing yields. CDs are not fully liquid; early cash-out means losing all interest. However, these risks are common for fixed income investments, as rising interest rates lower underlying value.

Conclusion:

Overall, my investment strategy is to balance risk and return by investing in short-term Treasury bonds and CDs while actively diversifying my portfolio. By avoiding long-dated securities and keeping my capital liquid, I can take advantage of better investment opportunities in the future while remaining motivated to stay informed and educated about financial markets.