Are you wondering the best way to invest cash you’ve accumulated? If you’re sitting on extra cash you may be wondering how to get a higher return than your savings account.
It can be challenging in today’s environment to find good fixed income options for your portfolio. As of November 2022, new issue CDs are paying in the 4% interest range. Higher rates are available for corporate bonds but may have to take on more risk by decreasing the credit quality or lengthen the maturity.
A concern is that rates won’t keep pace with current inflation figures. It can be difficult to know what do you do in a rising interest rate environment. Rising rates can put downward pressure on your portfolio until the CDs or bonds mature and can be re-invested at the current higher interest rates. This is what we’ve been experiencing lately. Investors have been getting hit from both sides with stocks and bonds being negatively impacted.
There are thousands of options to choose from when looking at different CD’s and bond types. This can cause some anxiety and be overwhelming. You may be asking yourself, what is the best choice between CDs and bonds? I will explain some differences below.
What is a Certificate of Deposit?
A CD, also known as a certificate of deposit, is a fixed savings account typically issued by a bank or credit union. This means you give the bank money for a fixed amount of time and you get paid a fixed amount of interest. Many times they will pay you interest at maturity or the end of the term. You can find other CDs that will pay on a periodic basis such as semi-annually as well.
You usually will have to hold the CD until it matures at which point you will get your initial investment back. If you need your money before the maturity date you will likely have to pay a penalty to get it out so this should be avoided if possible.
Is a Bank CD Safe?
Certificates of deposits are viewed as one of the safest investments available. This is because they are usually backed by an FDIC bank meaning in the event that the bank fails, they will be insured up to the limits of $250,000 per depositor and per bank for each ownership category. For example, if you have a joint bank account you can get additional coverage with a spouse.
What is a Brokered CD?
Brokered CDs are marketable securities. They can be bought and sold in the secondary market. You don’t have to hold them until maturity. If you need the money or want to sell them to re-invest elsewhere this can be done. They will fluctuate as interest rates go up and down.
Usually brokered CDs are considered bank products and you will receive FDIC insurance. That said, this is not always the case and some may be considered securities. You should perform more due diligence when investing in brokered CDs to make sure you are buying from a stable institution.
Marketable CDs will usually pay higher interest rates and can have longer terms than traditional CDs held directly at a bank or credit union. If rates decrease this usually means your CD will increase in value because it’s paying a higher rate than the current offerings. Rate declines can make it an attractive time to sell your brokered CDs.
The opposite is also true, as previously discussed. As rates increase this can decrease the value of your holdings since they’re paying less interest than the current market.
What is a Bond?
A bond is a fixed income instrument and is considered a security that is bought for investment purposes. Bonds are issued by various institutions like governments, cities, or corporations. It is considered a debt instrument. The party issuing the bond is the creditor or borrower, and the party purchasing the bond is the lender so to speak.
Think of yourself as the bank when investing in bonds. You are loaning someone money and expect to receive interest for a given period of time. Bonds are issued for a certain period of time and pay a fixed amount of interest usually semi-annually but can be other frequencies. Bonds will fluctuate in value based on the current interest rate environment.
Is It Safe To Invest In Bonds?
There is a risk spectrum when investing in bonds. Safer bonds are usually government-issued like treasuries or inflation-protected securities. This is because they are backed by the full faith and credit of the government.
The risk profile begins to increase once you start looking at revenue bonds issued by cities to fund projects and corporations looking to raise capital for investment. Corporate bonds usually pay higher rates, but you will need to look at the credit quality of the company you are buying bonds from.
Investment-grade bonds are considered bonds that are high quality with a smaller likelihood of bankruptcy. Credit companies such as Moody’s will have a rating scale that classifies investment grade vs. non-investment grade.
As you go down the scale the risk profile increases accordingly. You will receive a higher interest rate from a non-investment grade bond but there is a higher likelihood of bankruptcy and you potentially losing your investment.
What’s Your Tax Bracket? Tax Considerations for Bonds.
If you’re in a high marginal tax bracket you may want to consider investing in municipal bonds. These are bonds issued by states, cities, or governments and you can receive interest that is tax-exempt.
You can calculate the tax-free yield and tax-equivalent yield to compare different offerings to see if a municipal bond makes sense.
Obviously, the higher your tax bracket the more money you will save and the more attractive the municipal bonds will be.
Risk Tolerance & Goals
Your risk tolerance and goals will be your best barometer in determining how you should invest your money. These two things need to be aligned.
You don’t want to necessarily take on a lot of risk if you need the money in the short term. This is true even if you have a risk tolerance for it. This could result in loss of funds by the time you need the money due to the fluctuations in value.
Current Interest Rates & Chasing Yield
2022 has been a year of increasing rates and it seems they will continue to rise until inflation calms down. Rising rates will have a negative impact on marketable CDs and bond prices. This can be a bigger issue for longer term bonds as they are usually more sensitive to changes in interest rate.
Currently the yield curve is showing short term rates are higher than medium and long term rates. This is a result in the change in current rates.
The two things you need to consider when analyzing fixed income options are credit and term. If you can decide what kind of credit quality and term you want for your portfolio this will help you narrow your options.
The longer your term and the lower your credit quality the riskier your portfolio will be. This will also increase your expected return since risk and return are related. Investing in lower-quality bonds can open you up to an increased risk of the investment going belly up and losing your money.
Ask yourself if you’re chasing yield. This is when you look to maximize your return or yield by investing in very high risk, or speculative investments, that open you up to excessive risk. A change in market conditions can be detrimental to your portfolio when you go chasing yield.
One may be chasing yield in the junk bond or private credit markets. These markets consist of smaller companies that aren’t as financially sound as larger ones. They will take on high-interest rate debt. Therefore, they will pay bond investors higher interest but there is a higher chance some of these companies will not be able to meet their debt obligations and go into default.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.