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ETF Specialist

The Best Fixed-Income Investment

Bank CDs, not funds, currently offer a better bang for your buck.

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A version of this article will be published in the June 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

There were 31 short-term bond exchange-traded funds with a combined $60.9 billion in assets as of the end of May. They offer yields ranging from nil, in the case of SPDR Barclays 1-3 Month T-Bill (BIL), to more than 2%, in the case of AdvisorShares Newfleet Multi-Sector Income (MINC). The biggest, Vanguard Short-Term Bond ETF (BSV), yields a little more than 1%. A few, like  PIMCO Enhanced Short Maturity ETF (MINT) and iShares Short Maturity Bond (NEAR), step into the gap created by tighter money market fund rules.

Which one is best? None. Low policy rates, competition among banks for retail business, and tighter regulations have created an unusual environment where the highest-yielding bank CDs dominate virtually all short-maturity bonds and offer vastly superior risk-adjusted yields to most intermediate-maturity bonds.

As of this writing, Synchrony Bank and Barclays offer five-year CDs yielding 2.25%. There is no other fixed-income investment that I know of that offers the same yield for equal or lower risk. (Synchrony Bank is a subsidiary of  General Electric (GE) and was until very recently called GE Capital Bank, so we're not dealing with a fly-by-night operator here.)

Bank CDs, as you know, are insured by the FDIC up to $250,000 and are backed by the full faith and credit of the U.S. government. Their credit risk is nil.

Their duration is 1.7 years at most. That's not a typo. CDs can be thought of as putable bonds, where the lender has the right to demand principal back at any time, minus a modest penalty, regardless of what interest rates do. Barclays imposes an early-withdrawal penalty of 180 days' worth of interest; Synchrony Bank imposes a 270-day penalty. These penalties amount to 1.1% and 1.7% of principal, respectively. Furthermore, the penalties are capped. If interest-rates spike 10% overnight, you'd be hit with double-digit losses on all but the shortest-duration bonds, but your CDs will lose almost nothing, and you'll have the option to reinvest at these higher rates. The drawback is if interest rates fall, a bank CD's redeemable value does not rise. However, it's still intrinsically more valuable because of its above-market yield.

Keep in mind I'm talking about bank CDs. Brokered CDs, which you buy through a broker like Fidelity or an advisor, are rarely putable and often have fees attached to them.

There is no better deal out there in fixed income. To get a 2.25% yield in Treasuries, you have to buy seven-year bonds, which have durations of 6.5 years. To get a 2.25% yield in investment-grade corporates, you need to buy four- to five-year bonds, which have durations of almost four years, plus the nasty tendency to fall in bear markets.

To be fair, you can get a capital gains bonus in bonds by employing a strategy of "rolling down" the yield curve. It works like this: Identify a steeply upward-sloping part of the yield curve and buy maturities on the longer end. As time passes and the bond's maturity shortens, its price rises as its yield falls. Sell the appreciated bond and repeat. Roll yield can add 1% or a little more in total return. Of course, it isn't a free lunch, as one bets on the shape of the yield curve.

A 2.25% yield on a putable, liquid, credit-risk-free bond is such a good deal that I would own it over bank loans, short-duration junk bonds, and even the broad bond market.

So far it sounds like I'm describing a unicorn or incredible stupidity on the banks' part. Surely there's some catch--where's this free lunch coming from? There is no catch. Banks can and do subsidize their high-yield savings products for various reasons:

1) To get new retail clients, who are especially sticky and can be cross-sold higher-margin products.

2) To get cheap funding. Ally Bank, which for a long time offered some of the most generous yields on their savings products, is rated junk and so must pay high yields to borrow from the market. FDIC insurance effectively subsidizes Ally and other low-credit-quality banks.

3) Finally, banks can offer generous yields because many savers don't pull their principal when market interest rates go up. The banks offering high yields are to some extent sharing a benefit that would have otherwise accrued to them.

In Synchrony's case, GE is preparing for an imminent spin-off and is likely subsidizing the CDs to bulk up its deposit base and client numbers.

Market forces do not equalize yields across all CDs and between CDs and the bond markets. FDIC-insured CDs are largely limited to retail investors. Believe me, if PIMCO or BlackRock could invest in 2.3%-yielding, FDIC-insured five-year CDs, they'd be backing up the truck rather than making do with Treasuries.

Practical Consequences
Given the relatively attractive features of the best five-year bank CDs, how does one use them in a portfolio? This analysis assumes you're dealing with sums big enough that the hassle of opening up a new account is far outweighed by the marginal benefit.

The biggest consequence I think is the best-available bank CD becomes the "risk-free" benchmark against which to compare all current and prospective investments. In this light, most bonds turn ugly.

Keep in mind that credit bond yields are not what you're actually going to get. Defaults happen. Any fair comparison between a risk-free yield and a credit yield must take into account expected losses. The Bank of America Merrill Lynch U.S. High Yield Master II Index yields 5.4%. Historically, typical high-yield funds have lagged this index by about 1.0% even before fees (owing to the high cost of transacting illiquid bonds), and the junk bonds have lost about 2.7% annualized to defaults. Tack on management fees, and you're left with an asset class that seems to offer lower returns and higher risk than the humble CD.

Even  PIMCO Total Return ETF (BOND) looks ugly. Historically, Total Return has beaten the Barclays U.S. Aggregate Bond Index by 1%, putting it near the top of all actively managed bond funds. The Aggregate Index yields 2%. If PIMCO's historical alpha holds, Total Return offers a 3% prospective nominal total return. One has to be wildly optimistic to think PIMCO can do much better over the long run, as the firm is now managing hundreds of billions of dollars and its strategies and moves are aped or anticipated by others. 

I suspect most investors could improve their portfolios by dumping their bond funds for CDs and using their freed-up risk capacity to buy foreign equities, which I believe offer a better risk/reward trade-off than most bonds.

To sum up:

  • Barclays and Synchrony Bank offer 2.25% yields on five-year CDs. These CDs offer higher yields and lower risk than most short-term bond funds.
  • The five-year CD has a much better risk/reward profile than most intermediate bonds.
  • Most investors should focus their fixed-income investments in five-year CDs and take risk in foreign equities, which are still fairly cheap.

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Samuel Lee does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.