Rethinking CDs

Dante warned us that there’s a special place in the underworld for people who make puns about the financial and musical uses of the term “CD” but I like to tempt fate.

I’ve been thinking about reviving my old CD collection. No, I’m not talking about deleting iTunes. I’m talking about inviting some certificates of deposit into my retirement portfolio.

People generally think of CDs as investments for risk-averse retirees—or, at least, we did before interest rates plummeted to historic lows. And you can’t usually buy CDs inside your 401(k) or other workplace retirement plan, even if you want to.

Despite this, CDs have some peculiarities that make them worth a look, even if you’re a long way from retirement.

Certified financial planner Allan Roth (who did not invent the Roth IRA, though wouldn’t that be cool?) writes the Irrational Investor blog and is such a strong proponent of CDs that he is considering changing his name to Allan CD (not really).

Banking on CD singles

Two years ago, I wrote about using CDs for your emergency fund. That was Roth’s idea and I’m glad I took his advice. Most of my emergency fund is sitting in CDs paying 2.74%, with a tiny 2-month early withdrawal penalty. That may not seems like a high interest rate, but compared to an online savings account paying less than 1%, it’s delightful.

Roth says there’s no reason to stop there; I should also consider using CDs as a replacement for bonds in my retirement savings. “I have roughly 70% of my fixed-income portfolio in CDs,” he says.

Why? Because CDs offer two features bonds don’t:

Higher interest. Right now you can buy a 5-year US treasury bond paying 0.92%. An equally safe FDIC-insured 5-year CD from Ally Bank pays 1.79%. A 7-year CD from PenFed Credit Union pays 2.75%, while the comparable treasury bond pays 1.49%. Why would anyone buy the treasury bond?

Less interest rate risk. When interest rates go up (and wouldn’t that be nice?) bond prices go down. That’s not true of CDs, which don’t fluctuate in value. If rates go up, you can just break the CD, pay the penalty, and buy a new CD—or a bond, if bond rates are superior in the future. Of course, if interest rates go down, CDs don’t go up in value, either.

We could also compare CDs to a broad-market bond index fund like the AGG ETF, which has a yield of 2.04% and a duration of 4.3 years. That’s not terribly different from the rate on the Ally Bank CD, and it introduces default risk: about a third of the bonds in the index fund are corporate bonds, which are riskier than US government bonds.

“So I’m getting almost the same yield, I have less default risk, and far less interest-rate risk,” says Roth. Why should this situation persist? “There’s this inefficiency we can take advantage of that Goldman Sachs can’t,” he says. CDs are only risk-free up to the federal insurance limit of $250,000 (double that for a joint account; even more if you open CDs at multiple institutions). I consider that a lot of money. A giant investment bank doesn’t. A bank that needs to bring in deposits has to offer a higher CD rate, but doesn’t have to convince us that the bank is secure, because deposits are insured.

Smooth or chunky?

I have no argument with any of this, and yet I haven’t put any of my retirement portfolio into CDs for several reasons, some more legitimate than others. Listen in while I try to talk myself into it.

Bond funds are smooth; CDs are chunky. Every month, I make a contribution to my retirement account. Setting up an automatic contribution to a bond fund is a snap. No bank that I know of allows you to automatically buy CDs every month, so I’d have to do it manually. I hate manual transactions. Furthermore, it’s almost time to rebalance my investments. This will involve selling bonds and buying stocks. With a bond fund, that’s two clicks of the mouse. With a collection of CDs, it means either redirecting a few months of future contributions to stocks (and remembering to set it back later) or calling the bank to break some CDs. Which brings us to…

Breaking CDs feels wrong. “There is the psychological aspect of a penalty, which you need to get over,” says Roth. “I have the right to sell my CDs back to Ally Bank.” If interest rates rise and people start breaking their CDs all over the place, that might turn out to be the end of the small early withdrawal penalty, but that’s no reason you and I can’t break CDs today.

My bond funds did great last year. In 2011, I got double-digit returns on bonds. If I’d bought CDs instead, I would have made maybe 2.5%. This is an absolutely terrible reason to favor bond funds, however, because it’s looking only at the first year of a five-year investment. What goes up will probably come down.

There are no inflation-protected CDs. I prefer inflation-protected US treasury bonds (TIPS). In the world of CDs, there’s no such animal. Roth says it’s unnecessary: with high inflation comes high interest rates, and again, you can just break your CDs and buy higher-yielding ones. There’s your inflation protection.

The verdict

Well, I’m convinced: by adding CDs to my retirement portfolio, I can get a higher return and take less risk. But I’m still sticking with bond funds.

Why? For simplicity’s sake. My wife and I have all of our individual retirement assets at a single mutual fund company. Buying CDs would mean opening IRAs at a bank and moving money between the fund company and the bank. Smells like paperwork. Then we’d find ourselves tending a herd of CDs, making manual transactions and having to figure out when to call the bank to break them.

This is just too much of an affront to my preference for keeping investing simple (my wife and I own a total of four mutual funds) and automating wherever possible. As Mike Piper, of Oblivious Investor, put it recently, “As to embracing simplicity for simplicity’s sake, you bet I do.” Me too!

If you’re a more hands-on investor, however, and want to add some CDs to your portfolio, you can buy them for your traditional or Roth IRA at most banks and credit unions. You can compare CD rates and terms on Mint.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.