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  • Buying CDs Through A Brokerage

    Posted by Carl from Chicago on January 9th, 2010 (All posts by )

    Recently I covered iBonds, which are a government bond that you can purchase online that provides assurance against increases in inflation and other tax benefits. The amount you can purchase is limited, however, to $5000 / year, and you can’t redeem them for 12 months, which makes them unsuitable as a short-term cash vehicle.

    Certificates of Deposit (CDs) Through a Brokerage:

    If you are looking for a practical way to earn interest income with the minimum risk possible than certificates of deposit are a good alternative. When I was growing up you had to physically go to a bank and set up a CD, and then you had to retain paperwork for each instrument. In addition, you wanted to disburse your funds among a number of banks to get around FDIC limits, as well. Finally, the CDs were not easily redeemed, although you could redeem them in some circumstances depending on the issue with a penalty on interest.

    Today – all of above disadvantages and inconveniences with certificates of deposits have been eliminated. You can buy CDs online (I used to go through a voice broker, but last time the guy showed me how to do it myself, online, so now I will just purchase them that way), they are integrated with your brokerage statement so there is no additional paperwork (on issuance, or at year end for taxes) beyond what you already receive, and also there is a “secondary” market when you can re-sell your CD if you need the proceeds sooner. There is no “guarantee” that you will be able to sell your CD at the price you want, but since a CD is a simple commodity with a rate, timing payment frequency, and a duration, I’d expect that you’d be able to sell it for something very close to the market price and receive not only your cash back but essentially be made whole on your interest. However, the overall interest rate market may have changed which would mean that your CD would be worth “more” or “less” if you had to sell it – longer dated CDs that I purchased a couple of years ago are now selling for more than 100 cents on the dollar (say 102) but that would only come into play if I decided to sell them prior to their redemption date, which I don’t plan to do.

    Creating a “Ladder”:

    The typical way to invest in bonds or CDs to earn interest is to create a “ladder”. You purchase equal lots spaced out over equal intervals (in this case it is 5 “lots” with 1 year intervals), and as the current CD matures, you re-invest that money as the longest purchase in your range (the 5th year). Let’s look at my current ladder:

    The older CDs I have are as follows:

    3.9% through Jan 2011
    3.9% through Jan 2012
    4.1% through Jan 2013

    I had to fill in some gaps in my “ladder” recently. One of my CDs (yielding over 5%) hit its redemption date and the proceeds showed up in my brokerage account. Then another CD was from a bank that failed and the Federal government seized the bank and liquidated my CD and then the proceeds also showed up in my brokerage account (plus accrued interest). Without meaning to do so I “tested” the FDIC guarantee process and it worked very smoothly, in my case, at least.

    The new CDs I purchased were as follows:

    2.75% through January 2014
    2% through January 2012

    So in looking at this my ladder is a bit bent. I essentially am doubled up on the same maturity, January 2012, which is the 2 year point (from today). The “standard” item would have been to purchase a January 2015 CD, which would be essentially a 5 year maturity. Those CDs were offering around 3%, and I did not want to lock myself into a 5 year CD at such a low rate. Here is my current ladder:

    3.95% Jan 2011
    2.00% Jan 2012 (new purchase)
    3.90% Jan 2012
    4.10% Jan 2013
    2.80% Jan 2014 (new purchase)

    You can see how interest rates have declined over the last year or so. CDs that offered almost 4% are now down to about 2% for the same duration. This is a big drop for savers. Remember, too, that these are pre-tax rates – the after tax rates for these amounts are probably around 25% – 30% lower (maybe around 1.4% or so). The average interest rate across this portfolio is 3.35%, with my older purchases bringing up the total.

    The interest rates paid by banks are impacted by our overall interest rate policy. The current interest rate policy is near zero. I am not smart enough to predict when US interest rates will begin rising but it doesn’t seem feasible that our current almost zero interest rate policy can continue indefinitely. This is why I am “doubling” my ladder at about the 2 year mark; I’ll re-assess the situation then and if rates are higher I will be in a position to take advantage of them. They can’t get much worse (from an interest-seeking investor perspective, that is).

    In summary, purchasing CDs through a brokerage is a way to put your cash to work in an extremely low risk, easy, and liquid manner, especially if you just hold them through to maturity. This would not be the sole item in your portfolio, obviously, but everyone needs a secure component of their portfolio and CDs, along with iBonds and savings, can make up this “leg” of your financial plan.

    We will continue to cover other savings and investing outlets in future posts.

    Cross posted at Trust Funds for Kids and LITGM

     

    4 Responses to “Buying CDs Through A Brokerage”

    1. Anonymous Says:

      Another convenience of going through your broker, if the bank goes belly up, the broker will retrieve your CD money for you, though I believe you lose the right to the interest rate you “locked in”.

      So far the brokerages have remained in business, though I wonder if they are as solid as I like to believe. I’ve been with Fidelity for 20 years, and Bill Fleckenstein seemed to think they were solid. But many of these are private, and there is no real way to check their books, that I know of. I’ve considered moving my (little) money away from the east coast and back to downstate Illinois, where maybe it would get better use.

      Also, perhaps moving money to smaller banks for the CD’s, rather than letting the Citigroup type gangs run it, might decentralize some power?

    2. Carl from Chicago Says:

      You are correct that you will lose the interest rate that you “locked in”. I had a CD with an interest rate that I can’t replicate in today’s market and when the FDIC came in they just gave me back my principal plus the interest that had been accrued. I can’t speak for all situations but in my case they just gave me back the cash so it is a classic example of “reinvestment” risk.

      Each of the main brokerages are different – ones like Fidelity, Vanguard etc… I haven’t gone through it in total detail but they are insured through a government program called SIPC and here is their web site

      http://www.sipc.org/

      I think their biggest payout ever is related to Madoff

    3. bill Says:

      thanks Carl,

      My concern would be that with a major meltdown, SIPC is even more underfunded than FDIC. But then if they are both government sponsored, I suppose they would just “print” whatever is needed to cover those hundreds of trillions in derivative exposures, if major brokers happened to be playing in those waters, and that hundred year flood came around… again.

      It is all too arcane for me, but some $600 trillion in derivatives seems like an ocean, and there could still be a lot of people swimming naked. Our government is going all in to try to hold back the tide, and I just wonder if we aren’t being setup to take a bath.

      My depth of understanding is about as shallow as my analogy. :) But I do know many people are setting up some accounts in Canada, concerned that our government is eyeballing our savings a little too lustily … and Madoff may turn out to be a relatively small shark.

    4. tyouth Says:

      I usually get my CDs from Amazon.

      Just kidding Carl, good work.