Pivot To Brokered CDs Yielding Over 5% Now Before They Are Gone (US5Y)

My many years of investing in fixed income have taught me that there is a cyclical pattern as to where you can find the best fixed income investments. In this article, we will explore how to invest in each of these phases and help you understand where we are now.

The Three Phases of Fixed Income Opportunity

Rates Begin to Rise

As the Federal Reserve’s overnight rate begins to climb, short-term Treasuries are your best investment, especially those with maturities of only 1-3 months. That is because it takes some time for that rise in rates to affect longer rates, but if the rate increase is sustained for a few months, it will.

Be Careful in a Taxable Account Not To Overcomplicate Your Taxes

During this phase, if you are investing in a taxable account, it is best to stick with Treasury Bills bought at auction or on the secondary market as they won’t complicate your tax accounting at year-end. If you buy longer Treasuries on the secondary market of the same maturity as Treasury Bills being offered, things get complicated. Older bonds offered for resale that come with a low coupon (the semiannual interest you receive from the bond) will be sold at a discount. This means you pay less than face value and get much of your interest on the bond for the whole period only when the bond matures at face value, rather than from the semiannual coupons.

When you are investing in a taxable account and buy any bond save a Treasury bill (with a maturity of a year or less) on the secondary market, you will usually have to pay the interest the current holder would have received had they continued to hold. When it is tax time, you must account for both the discount and for the interest that you paid at the time of purchase. This can get complicated if you use tax software like H&R Block, Inc. (HRB) or TurboTax software, forcing you to pay for a tax preparer unless you are comfortable with tax accounting yourself.

You can also buy Treasury Bills at auction. Your brokerage should allow you to sign up for auctions. You can find out what auctions are currently scheduled by visiting this Treasury Direct Upcoming Auctions page:

https://www.treasurydirect.gov/auctions/upcoming/

Alternatively, in this first phase as rates begin to rise, you might prefer to invest in a money market mutual fund offered by your brokerage. These will pay a little less than treasuries during this phase, but the price of a share stays constant at a dollar, and investing in a money market fund gives you the option of waiting until longer rates go much higher.

If you invest in a money market fund in a taxable account, be aware that quite a few money market funds with the words “Government” or “Federal” in their titles do not primarily invest in the kinds of government offerings that are state and local tax exempt. Go to the website of the company offering the money market fund, pull of the information page for each fund, and check the breakdown of what the fund actually holds. Repurchase agreements (repos) are not exempt from those state and local taxes and currently are found in many “Government” funds.

Below is the breakdown of the holdings of the Vanguard Federal Money Market Fund Inv (VMFXX):

Vanguard VMFXX Holdings Breakdown

As you can see, Vanguard’s Federal Money Market Fund was holding 41% Repos, as of October 31, 2023, the last date for which Vanguard provides information. Only funds with “Treasuries” in the title appear to currently hold only Treasuries and thus get the full benefit of the State and local tax exemption.

If you are in a state with a high state tax check whether your state will give you credit for the percentage of your holding in a fund like VMFXX that was invested in Treasury bills. Some, like Massachusetts, do, but California, New York and Connecticut may not. That is why if you have significant money to invest in a money market mutual fund and live in those states you should choose one of the state-specific money market funds that brokerages offer people living in such states.

The first phase of the Fixed income cycle began in March 2022 and lasted until very recently.

Rates Stabilize

After rates start to stabilize you will find the best yields between longer Treasuries and Brokered CDs. Which one is going to be best for you depends on two factors:

How sure you are you can hold the investment to maturity

That’s because if you have to sell a longer-term brokered CD before maturity you will almost always take a loss, since there is not much of a market for them. If rates go up after you purchase a brokered CD you can’t hold to maturity, the loss you take could be significant. There are no set “early withdrawal penalties” for brokered CDs as there are for those you buy at the local bank or credit union. You have to sell them on the secondary market via your brokerage to get out of brokered CD before it matures.

The interest from a brokered CD will be deposited in your settlement account by your brokerage, requiring no effort from you, unlike a bank CD where if you don’t take your money out within some set, very short period, the bank rolls over your CD, often at a much worse rate.

Treasuries, unlike brokered CDs are very liquid. You may take a loss if rates go up and you have to sell, but it will be far smaller than what you’d experience selling a brokered CD of the exact same yield and maturity.

How Brokered CD Rates Differ from Bank CD Rates

The rate you see on the listing of a brokered CD is the actual rate of interest that you will receive. You can’t reinvest the interest payments in that CD the way you can with a bank CD. However, you must keep in mind that the rates you see for bank CDs are always calculated assuming that you are reinvesting the interest. The actual monthly interest you receive will be computed at the APR rate which is often hard to find in a bank’s CD listing, not the higher APY rate which is what is displayed by the institution and assumes you hold to maturity and reinvest.

Only Buy Newly Issued Brokered CD

Most brokerages will sell you newly issued CDs without charging a fee, but if you buy CDs listed on the secondary market or sell one on that market there is a fee. Check your brokerage for the specifics.

There is currently no fee for buying or selling Treasuries on the secondary market at the brokerages I am familiar with.

Whether You Are Investing in a Tax Sheltered Retirement Account or a Taxable Account Makes A Big Difference

Treasury bills (issued with 1 year or less to maturity) and Treasury Notes ( issued with 2 – 10 years to maturity) are exempt from state and local taxes. This can make a significant difference in what your after-tax proceeds will be if you are buying an investment with a longer maturity.

Hence, if you are investing in a taxable account and have significant taxable income from interest, taxable social security, consulting, or your own business, you should compare the yield of a brokered CD with that of a Treasury using a Tax Equivalent Yield calculator to see which is the best deal. I personally use the one you will find at Fidelity. No Fidelity account is required to access this calculator.

When Investors Expect Rates To Begin to Decline

This is where we are now. At this stage, the Federal Reserve has not begun to cut rates and they are still letting the trillions of dollars of longer-term bonds they hold roll off their balance sheet and not buying new ones. Until very recently the Federal Reserve was pushing down longer bond rates by buying Treasuries with longer maturities. They stopped doing this in early 2022. Below you can see the history of the Federal Reserve’s Assets, which show you the extent to which they have bought bonds and the degree to which they unloaded some of those bonds they bought through the years since the Great Financial Crisis and then, to a larger extent, during the COVID recession years. As you can see they have a huge amount of bonds left that they must allow to mature and roll off of their balance sheet without being replaced.

Federal Reserve Assets July 30, 2007- Nov 8, 2023

Currently, despite everything the Federal Reserve governors have said, repeatedly in their press conferences and other speaking engagements, investors believe that the Fed will begin to raise rates within months and that they may pause letting the bonds they hold scroll off and even begin to buy longer-term bonds again. (I personally am not at all convinced this is the correct outlook, but that’s what the behavior of the bond market is currently predicting.)

CDs Begin To Be More Attractive

Because the process of issuing brokered CDs appears to be a more lengthy one, their yields tend to lag those of Treasuries as they are moving up. But they also lag them as Treasury rates begin to decline. Hence if you believe that rates are likely to start a continued decline this is the point where you will want to buy fixed income with longer maturities to lock down higher rates. I was very happy to be able to do this at the end of 2018 when the Federal Reserve was pausing their rate increases and there were still 5-year brokered CDs paying the top rate of 3.55%.

Right now there are a few 5-year CD offerings on brokerage bond platforms yielding between 4.90% and 5.05%. These compare very well with current rates offered by Treasuries of the same maturity as you can see from the bond rates available on Vanguard as I write:

(Note: I display Vanguard’s list of available bonds because it can be viewed without signing in.) I personally prefer to buy bonds at Schwab because they usually have many more Treasuries and Brokered CDs listed that can be bought in increments of only $1000 rather than the higher minimums other brokerages may require. Schwab’s bonds when bought in small quantities are often not priced any higher than those that require larger minimum.

The CD-Treasury Spread Has Grown Dramatically

As you can see from the table above the spread between the top yielding 5-year brokered CD and Treasuries of the same maturity as of today had grown to 58 basis points. This cancels out the advantage of Treasuries for most people investing in Taxable accounts except for those with huge taxable incomes who live in states with very high state and local taxes.

Though these brokered CDs will continue to be harder to exit, due to the lack of liquidity, if rates drop back to 3% or lower over the next 5 years you will be very glad to own them.

This phase is where we are right now. I have been rolling my maturing very short treasuries into 4 and 5-year CDs over the past few weeks. There were still some left this morning, even as corresponding 5-Year Treasury bond (US5Y) has seen its rate drop over one day, as I write, by a full 4.83%.

Beware of Callable Bonds and CDs

You may wonder why I’m not recommending some of the higher yielding bonds listed in the Vanguard table above, such as Agency and Corporate bonds. There are very good reasons. Let’s split out the two kinds of bonds to examine them.

Available Agency Bonds are Callable

Agency bonds like those issued by Federal Home Loan Banks (FHLB), Federal Farm Credit Bureau (FFCB), TVA, The Federal Home Loan Mortgage Corp (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae) have very high credit ratings. FHLB, FFCB, and TVA, bonds are exempt from state and local taxes just like Treasuries are. They are not guaranteed by the Federal Government but they currently have the same credit rating as Treasuries.

Unfortunately, the agency bonds offering the high yields that you see above are universally callable. This means that the bond issuer can cancel the bond and give you back your money at any time after a date specified in the description of the bond. Thus if rates go up you find yourself stuck with a lower-yielding Agency bond, but if they decline your bond is called away and you have to reinvest the principal in something pays a lot less.

I have been buying Agency bonds this year that are exempt from state and local taxes, but when I buy them I assume they will be called the moment rates start to decline, so I buy them only if they are a much better deal than Treasuries of CDs maturing at the first call date and treat them as very short term investments. So far several of my agency bonds yielding over 6% have been called as soon as rates for new agency bonds have dropped below my bond’s issue yield when they reach their first call date. That is fine because I held them for several months and received that high rate through those months.

If rates drop after the first call date most callable bonds can be redeemed at any time by the issuer with a week’s notice.

Clearly, this is not an investment you buy to give you a high yield for years to come when you think rates are about to decline.

Corporate Bonds Can Be Called Too But Have Additional Significant Company Risk

Corporate bonds are far more complex than the bonds issued by the Agencies that offer Agency bonds. Each one is offered with often unique conditions spelled out in documents that ordinary investors like me are unlikely to understand.

Ordinary investors without forensic accounting experience are also unlikely to be able to understand the financial condition of the companies that issue these bonds. Hence if you are buying corporate bonds without a background in business accounting you will have to depend on the judgement of an advisor of some sort, which means you need to do due diligence to determine the extent to which that advisor is working to enrich themselves rather than you.

If you take the advice of an advisor you would want to know at a minimum:

What is their training that allows them to evaluate the safety of a given bond? Are they getting paid a commission for selling the bond? Will they be updating you on the creditworthiness of the issuer of your bond so that you don’t find yourself holding a “junk bond” whose yield has surged, depressing its current value, and whose ability to repay you your full investment may have been compromised by cash flow problems within the corporate issuer. Do they themselves have an investment in the product they are advising you to buy?

Add to this that many of the better quality corporate bonds are callable and you can see why they are not something that the average investor who doesn’t make investing a full-time hobby should dabble in.

When Rates Start to Decline

When the Federal Reserve starts cutting the overnight rate, which is currently set at 5.25%-5.50% we move from speculation to cold hard fact. If they stop letting their longer-term bond holdings roll off or start buying new ones, the impact of their actions on interest rates will be much greater.

By this time, the best yields will be found at online credit unions and smaller banks that only offer direct CDs. Back in early 2019, I was able to buy CDs yielding 3.50% as long as 3 months after brokered CDs offering rates that high had completely vanished and Treasuries were paying far less.

You can see the current rates available directly from banks and credit unions along with quality ratings of those institutions and reviews from people who have used them at DepositAccounts.com. What CDs will be available to you depends on where you live, as many of these credit unions limit membership to people living in certain regions or working for certain companies. Rates will be much higher in areas with strong economies where consumers are still taking out mortgages and car loans than they are elsewhere.

Before you jump at one of these direct CDs, you should read reviews available on Deposit Accounts to find out what the catches may be. There are many! I will write about these options at some future time if they become appealing. But right now given the hassle involved in buying from individual financial institutions, their offerings are not yet competitive with easily managed brokered CDs. Be aware that the early withdrawal penalties being assessed by most credit unions and banks now have risen dramatically over the past couple years, to where breaking your CD before maturity can be expensive. You may lose a year of interest or even more for a longer CD. If you sell after a short holding period and haven’t earned a year of interest, some institutions will even dock a penalty from your principal.

Bottom Line: This May Be A Brief Opportunity To Lock Down the Current High Rates

If rates have really topped out, the current yields available in brokered CDs right now, those rates that are significantly higher than those of Treasuries of the same maturity will quickly disappear.

If you believe that we are heading for a recession that may be longer than the ones we have seen over the past 12 years, this is the time to lock in the currently high 5-year rates. A longer recession is very likely to damage corporate earnings and diminish both their share prices and the dividends these companies pay out.

A prolonged recession could be especially challenging for dividend focused ETFs like the Schwab U.S. Dividend Equity ETF (SCHD) or The Vanguard High Dividend Yield Index Fund ETF Shares (VYM) which hold the stocks of many financial institutions and consumer facing companies that would be hard-hit if more consumers with heavy loan burdens face unemployment.

One Caveat

The one factor that might make it premature to put all your free capital into 5-year CDs right now is this: the weakness of the latest Federal Reserve auction and the perception that the Treasury may have increasing difficulty in selling the amount of longer bonds that it needs to sell to cover the U.S.’ current deficit.

If you believe that this factor will make longer rates continue to rise, you might be more cautious in your investing. But predicting bond rates, while a bit easier than predicting stock prices, is still very difficult and it is very easy to make mistakes. if you have not locked down any fixed income investments yielding the highest 5-year rates today, even in the face of uncertainty about the future it would be prudent to invest at least some of your available cash in them.