The Finance Buff

Stable Value Fund vs Bond Fund vs CDs

Harry Sit — Mon, 20 May 2013 12:29:00 +0000

CDs are better than bond funds these days even though financial advisors rarely recommend CDs. Many 401k or 403b plans include a stable value fund. How do those compare to CDs and regular bond funds?

CDs are appealing for several reasons: higher yield, principal stability, and FDIC-insurance. Stable value funds share some of the same traits with CDs but not others. There are two general categories of stable value funds. Depending on the type, a stable value fund could be a very good alternative to a bond fund offered in the plan, or it could be just so-so.

Synthetic GICs: Bonds In a Wrap

In this setup, officially known as synthetic GICs, the fund owns a number of bonds, just like a regular bond fund. Then the fund buys a “wrap” from one or more insurance companies. The insurance companies use a formula to create a reserve when the bonds do well. They use money from the reserve to tide over lean times; if necessary, the insurance companies may even kick in a little bit of its own money temporarily.

To the participants, the stable value fund behaves like a savings account. The interest rate is announced and reset from time to time.

When the fund only invests in short-term bonds, after paying the insurance companies for the principal guarantee and paying an asset manager to manage the bond portfolio, there isn’t much left to pay the participants. I don’t see much of a point in this type of funds. At best it’s a little better than a money market fund.

My employer’s 401k plan offers a stable value fund like this. It owns short-term bonds (1-5 years). After an expense ratio of about 0.5%, the fund pays 1.25% at the moment. It’s better than a money market fund but it’s not much better than a regular short-term bond fund.

Traditional GICs: Just The Guarantee

In this second type of stable value funds, one of more insurance companies just come out and quote a guaranteed rate. These are known as GICs, or traditional GICs, to differentiate them from synthetic GICs. The fund doesn’t own any underlying bonds. It owns only the insurance companies’ words: a giant IOU. The insurance companies take the money and invest it themselves, often in longer term bonds.

The guarantee is of course is only as good as who’s guaranteeing it. In synthetic GICs, if the insurance company fails to perform, at least the underlying bonds are still there. Here the fund only has the guarantee.

Although it sounds risky, it can be argued that the insurance company’s asset pool is much larger and more diversified than the bonds a particular stable value fund can own. TIAA Traditional, available to many educators, falls into this category.

The yields from traditional GICs are usually much higher, because the insurance companies are able to invest in longer term bonds. Some funds of this second type are currently paying 3% or more. If the underlying insurance company is strong or there are several strong insurance companies, a stable value fund like this could be a very good alternative to regular bond funds.

If my employer’s 401k plan has a fund like this, I would be comfortable with investing in it, as long as I see the insurance companies making the guarantee are reputable and strong. After all, if I trust an insurance company to pay out a large sum if I die or become disabled, I would be OK with investing a much smaller sum against the insurance company’s guarantee.

Rates Are Not Fixed

Unlike a CD, the rate paid by a stable value fund is subject to change, monthly, quarterly, or whenever, similar to a savings account. If interest rates are falling, you are not going to get the capital gains enjoyed by regular bond funds; you are also going to receive less and less interest, similar to what happened to savings accounts. If interest rates go up sharply, you won’t have the capital loss, but the yield on a stable value fund probably won’t follow the rates up right away either.

If yields are similar, CDs in an IRA are still better because the rates are guaranteed for the life of the CD, and because FDIC insurance beats the guarantee by an insurance company. If a stable value fund pays a higher rate, using the stable value fund would be a good alternative.

Reference: Stable Value FAQ, Stable Value Investment Association.

[Photo credit: Flickr user Moomettes]

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Friday Reading: Pluralistic Ignorance

Harry Sit — Fri, 17 May 2013 12:28:00 +0000

Frakt on Medicaid and the Oregon Medicaid Study by Russ Roberts at EconTalk

What a surprise to hear my former co-blogger Austin Frakt interviewed on the popular economics podcast EconTalk. Well done, Austin!

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What is Behavioral Economics? by Dan Ariely on Vimeo

Duke University behavioral economics professor Dan Ariely explains pluralistic ignorance. Be ready for a good laugh. I’m listening to Professor Ariely’s book The (Honest) Truth About Dishonesty on audiobook. It’s quite interesting.

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The returns of stocks with less risk? by Larry Swedroe at CBS MoneyWatch

Investor advisor Larry Swedroe briefs us on research on low volatility stocks. Researchers and Wall Street are always looking for a better mousetrap. It’s uncertain whether low volatility is a distinct edge, a different manifestation of value, or just noise.

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How They Do It Elsewhere by Steven Greenhouse at New York Times

That is how other countries structure their retirement plans. I’m for universal mandatory contributions to privately owned accounts.

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What Do You Think of the Thrift Savings Plan? by Matthew Amster-Burton at MintLife

Such universal mandatory contributions to privately owned accounts can just go to the TSP. Matthew suggested a good test question for a financial advisor: ask for his or her opinion about investing in the TSP. Brilliant.

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Public Pensions: Nice Deals If They Can Be Delivered by Scott Burns at AssetBuilder

I don’t know why public pension plans are still selling extra years of service (i.e. additional future benefits) at a vast discount. Great deal for the employees. Raw deal for the taxpayers. Classic agency problem. I’m outraged.

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Portfolio Management vs. Financial Planning by Mike Piper at Oblivious Investor

Pay good money for the advice. Do the administrative chores yourself.

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Staying the course by Steve Holman at Vanguard Blog

Steve points out that people spooked by the fiscal cliff missed a 10% up swing. Staying the course is good but I wouldn’t use the 10% up swing as evidence for anything. Had the market declined by 10% after the fiscal cliff talk, does it mean staying the course is bad then?

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Next up: 10-year TIPS reissue will auction May 23, 2013 by David Enna at TIPS Watch

Not worth it. Buy I Bonds.

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Mountain America Credit Union 5-Year CD by Kevin at Kevin On Investing

Kevin documents how to buy a CD at a credit union with money in an IRA at a different place. It’s much easier than most people think. Try it once and you will be an expert. Always remember it’s not all or nothing. You can have both bond funds and CDs.

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Is Angie’s List Worth the Money? by Michael at Financial Ramblings

Michael gives a detailed account of finding a plumber on Angie’s List. I had good results with Yelp.

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Pay a Fee For Better Value

Harry Sit — Mon, 13 May 2013 12:25:00 +0000

The word "fee" has a negative connotation. I’m not sure why when a fee is just a price tag on a service. Brokerage firms have to advertise "no fee IRAs." Credit card companies say "no annual fee." Is a no-fee product necessarily better than a product with a fee?

I see heirloom tomatoes selling for $4.99/lb at the store. I’m not that crazy about tomatoes but I don’t cry bloody murder when I see the price tag. I leave those heirloom tomatoes alone and let someone else have them. I’m sure plenty of people buy them; otherwise the store will have to throw them away every week. Those customers voluntarily pay the price because they value heirloom tomatoes.

Merriam-Webster dictionary defines the word fee as "a sum paid or charged for a service." I had a haircut last week; I paid a haircutting fee. My Costco membership was due for renewal last month; I paid the membership fee. Millions of other Costco members pay Costco every year for the privilege to shop there when other stores welcome them with "no shopping fee."

I look at the services I use. Many charge a fee when no-fee services are available elsewhere. I find that the services I use that charge a fee often deliver a better value than services that don’t charge a fee. Is it universally true that you get what you pay for? Of course not. But you shouldn’t automatically reject a service only because it charges a fee when other similar services don’t charge.

Costco is one example. People pay a fee to shop there because it offers good prices. If you look at Costco’s financials, you will see Costco’s profit is largely from membership fees, not from selling merchandise. The "no shopping fee" at other stores are made up by higher prices.

Fidelity Investments is another example. I have my solo 401k there. I pay $8 a trade when I buy Vanguard ETFs. If I move the account to Vanguard I will not pay a fee when I buy Vanguard funds, but I will be limited to funds that end up costing me more in the long run.

The two credit cards I use most often both have an annual fee. I still come out ahead of alternatives after paying the annual fee.

Because most people are very much against paying a fee, businesses know they have to deliver value when they charge a fee for a service. When they have a hard time selling the fee product, they have to keep enhancing the value proposition, to a point where a fee-product delivers much better value than a no-fee product. Not always true, but it happens.

Now it’s your turn. What is it that you pay a fee when other services don’t charge? What do you get in return?

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Friday Reading: Where to Retire

Harry Sit — Fri, 10 May 2013 12:25:00 +0000

One Perspective on the Best Places to Retire by Ann Carrns at New York Times Bucks Blog

I’m thinking I should just experiment with many places when I retire. Live in one place for a few months to a few years depending on how I like it. Move on to the next.

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Retirement Countdown: Sheila Downsizes at Squared Away Blog

Downsize and/or move to a less expensive area, especially when you are no longer tied to a job. See previous post Lifestyle Design: Choose Where You Live.

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I Know I’m Supposed To Follow My Passion. But What If I Don’t Have A Passion? by Chana Joffe-Walt at NPR Planet Money

There’s a passion and there is practicality. I still think following one’s passion is really a luxury that too many pursue but can’t really afford.

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Income stability matters in your portfolio by Larry Swedroe at CBS MoneyWatch

Larry is talking about labor income stability. I would also add the size of the labor income relative to the portfolio also matters. If you are able to earn back what you lose in a bear market quickly through labor income, then you wouldn’t worry as much about a bear market.

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Reducing bonds? Proceed with caution by Vanguard Research

A research paper by Vanguard showing the role of bonds, or rather fixed income, in a portfolio. Always remember reducing bonds does not mean increasing REITs, dividend stocks, commodities, etc. You can reduce bonds but increase savings accounts, CDs, and I Bonds.

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Is It Time to Reform the 401(k)? by Matthew Amster-Burton at MintLife

Mandatory contribution to an individually-owned account invested in index funds — I’m all for it. Replacing 401k with pooled accounts subject to diversion and redistribution, no thank you.

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Does a Bond Fund’s Yield Tell You Its Level of Risk? by Mike Piper at Oblivious Investor

Yes and no. Find out why. If a CD’s yield is higher than a bond fund’s, does it tell you the CD has a higher level of risk?

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Future of Free Checking and Reward Checking Accounts by Ken Tumin at DepositAccounts.com

Great behind-the-scenes information on free checking and reward checking. I think free checking will stay. I doubt many people actually pay a monthly maintenance fee on checking accounts even at mega-banks. Most just keep a minimum balance to waive the fee. The opportunity cost on the minimum balance is miniscule.

Reward checking will also stay, albeit at a lower rate and a lower balance cap. Most people don’t keep that much in checking. A higher rate sounds rewarding but the actual payout isn’t costing the banks that much. People value the higher rate more than its economic value.

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Rejoice! Your House is an Investment Again by Rick Ferri at RickFerri.com

Your house has always been part housing consumption, part leveraged investment. The investment part doesn’t always give a positive return, just like any other investments, but when the return is positive, it’s quite strong, due to leverage.

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Thoughts On Paying Off Mortgage at The White Coat Investor

Mortgage rates have gone down to 2.5% for a 15-year fixed rate. Is it still worth prepaying? With a strong stock market, I can see people having second thoughts. If you have lower yielding fixed income investments though, it’s still worthwhile.

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Increase Tax Withholding On ESPP Gains

Harry Sit — Wed, 08 May 2013 12:35:00 +0000

I filed my taxes in the first week of April. I received paper I Bonds on April 29, just in time to have them earn the 1.76% rate in the first six months as opposed to the lower 1.18% rate. That’s good. The bad news is for the first time in 20 years I’m paying a underpayment penalty. Not a large one, $15, but it still irks me.

The IRS rules say you must pay by withholding or estimated tax payments:

90% of your tax liability for the current year; or
100% of your tax liability in the previous year (110% if income is over $150k)

I always do an estimate in October to see if I’m safe. If not I would ask the employer to withhold extra. I did the same last year but I didn’t know the "W-2 total YTD" on my paystub didn’t include income from selling ESPP shares even though the employer already knew the shares were sold by then. By the time the employer issued the W-2, the actual number was higher than I projected.

2012 was a great year for my ESPP. I bought the shares at $25 and sold at $45. Because there was no tax withholding on ESPP sale, and my income projection was off, my tax withholding ended up a little short of the 90% threshold.

This is a note for myself and others who run into the same [lucky] situation. Increase payroll tax withholding or pay estimated tax when you have large gains from ESPP sale.

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2014 HSA Contribution Limits

Harry Sit — Tue, 07 May 2013 12:31:00 +0000

The IRS announced contribution limits for Health Savings Account (HSA) for 2014.

HSA Contribution Limits

	2013	2014	Change
Individual Coverage	$3,250	$3,300	+$50
Family Coverage	$6,450	$6,550	+$100

You can only contribute to an HSA if you have a High Deductible Health Plan (HDHP).

HDHP Qualification

The IRS also defines what qualifies as an HDHP. For 2014, an HDHP with individual coverage must have at least $1,250 in annual deductible and no more than $6,350 in annual out-of-pocket expenses. For family coverage, the numbers are minimum $2,500 in annual deductible and $12,700 in annual out-of-pocket expenses.

	2013	2014	Change
Individual Coverage
min. deductible	$1,250	$1,250	-
max. out-of-pocket	$6,250	$6,350	+$100
Family Coverage
min. deductible	$2,500	$2,500	-
max. out-of-pocket	$12,500	$12,700	+$200

Reference: Rev. Proc. 2013-25, Internal Revenue Service

[Photo credit: Flickr user 401(K) 2013]

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Why Financial Advisors Favor Bond Funds Over CDs

Harry Sit — Mon, 06 May 2013 12:27:00 +0000

CDs are a better deal than bond funds nowadays but investors often don’t realize it. You would think financial advisors would be all over it when they are living and breathing in the investment world day in and day out. However, besides Allan Roth and Larry Swedroe, I haven’t seen many financial advisors recommend CDs over bond funds. Do financial advisors have the same blind spots as investors, not realizing that time has changed and that the best CDs are better than bond funds for their clients?

It’s possible, but I don’t think so. Financial advisors are smart and knowledgeable people. If you and I can figure it out, they sure can. Certain inherent conflicts make them still favor bond funds over CDs even if their clients are better off with CDs.

I’m limiting this discussion to financial advisors who are a fiduciary. In the previous post I mentioned that Ken Volpert, a Vanguard executive, made it sound like that bonds are the only option for fixed income and that CDs don’t exist. I used it as an example but I don’t really blame him. Vanguard is a good company but it’s not a fiduciary. They are not obligated to tell you that other products are better than the ones they sell.

A fiduciary such as a fee-only advisor is supposed to act solely in your best interest. Why is that you don’t hear as much about CDs from financial advisors?

Giving Advice vs Managing Assets

Some advisors charge hourly. It doesn’t matter whether you just want them to review your financial matters and give you advice, or you want them to actually do everything for you. You pay for their time and expertise. An hourly advisor can recommend that you buy CDs. You can ask the advisor to do it for you but it would be more cost efficient to have the advisor tell you where to buy and what to buy and then you just buy them yourself.

Hourly advisors are rare. Most other advisors charge a percentage of the assets they manage for you. If they tell you to take a chunk of money out of the assets under management to buy CDs, their fees will plunge as a result. It’s hard to justify charging a percentage on the CDs you buy directly from a bank or credit union, in the same way the financial advisor can’t charge you a percentage on the value of your house.

The CDs that financial advisors can buy in brokerage accounts don’t pay nearly as well as the best CDs sold directly by banks and credit unions. Even if you agree to pay the same percentage-of-asset fee, the advisor is not going to fill out forms with a credit union and buy the CDs for you there.

When I worked for an investment advisor years ago, all clients’ assets were held at Schwab. With software provided by Schwab, we were able to download the positions and values for all accounts in one shot. The portfolio management software Axys was able to generate all the reports for all clients. With a few clicks, the software would generate all the rebalancing trades and upload them to Schwab. Having bond funds in the accounts makes this very easy for the advisor.

Buying CDs for you at an online bank or credit union will take too much staff time. Even if you buy the CDs yourself and you agree to include the value for the fee calculation, they still have to get the current values from you every quarter to update their software. That’s just too much work for the advisor.

While your bottom line would improve if you buy CDs but if it’s going to hurt the financial advisor’s bottom line or cause inconvenience to their operation, they just aren’t going to tell you to sell bond funds and buy CDs. An individual investor doesn’t need the efficiency a financial advisor needs for managing many clients’ accounts. When you use a financial advisor to manage your assets, you are forced to go by what’s convenient to the advisor.

Investment advisor Larry Swedroe said in an interview in December 2012* that his firm Buckingham Asset Management had been buying a lot of CDs.

“Lately we have been buying lots of CDs, which if you stay within the FDIC limits you have the same credit risk (none) as you do with Treasuries but with quite a bit higher yields. We’ve even been buying them in taxable accounts for many investors, at least at the shorter end of the curve (too many investors just automatically assume that municipals will be better in taxable accounts).”

Buckingham must have some special arrangement with the banks because of its scale. A smaller firm wouldn’t be able to do so. Still, I wonder how the rates Buckingham gets for its clients compare to the best rates offered by online banks and credit unions.

I relate to my experience with getting my washer repaired. Getting the advice on what to do is the most valuable part. Actually doing it is easy. When you bundle the advice with action, you are not getting the best advice from the advisor because the advisor is concerned about fees and administrative efficiency. I would seek to separate the advice function from the administrative function. Pay for the advice. Let the customer service reps at banks and brokers do the administrative tasks.

* Reading the full interview requires registration. Get a login and password from bugmenot.

[Photo credit: Flickr user SalFalko]

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Friday Reading: Internet Retirement Police

Harry Sit — Fri, 03 May 2013 12:31:00 +0000

Meet Mr. Money Mustache, the man who retired at 30 by Kelly Johnson at The Washington Post

Blogger Pete MMM retired at age 30 but he still has a rental house and a blog. People debate whether he’s really retired. Pete calls doubters the Internet Retirement Police. When I retire if I still keep this blog, will the Internet Retirement Police nab me too?

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The 401(k) debate by Steve Utkus at Vanguard Blog

You would think a documentary that shines light on high fees in 401k plans would be fully endorsed and promoted by the low cost leader Vanguard, right? Not exactly. Steve calls it as he sees it. That’s rare.

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Are Retirement Accounts Flawed? by Larry Ludwig at Investor Junkie

Another take on the PBS documentary The Retirement Gamble. Larry points out that the attack on 401k fees isn’t aimed at merely lowering those fees. The real agenda is to replace the 401k with a government-run American Retirement Account, guaranteed to return 3% above inflation. Hence the title The Retirement Gamble not Investing for Retirement. How can anyone guarantee away the inherent risk in investing is the question.

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Getting Changes in Your 401(k) by Mike Piper at Oblivious Investor

If you just want to lower the fees in your 401k plan, read these suggestions.

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Is Capital Loss Harvesting Overvalued? by Michael Kitces at Nerd’s Eye View

Yes it is. It helps a little bit. A small loophole I won’t miss if it’s closed.

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I Finally Broke Down and Bought a New Car. Yes, New. by Len Penzo at LenPenzo.com

Financial bloggers don’t have to apologize for buying a new car. I bought my car new. My wife bought her car new. The cars we replaced were also bought new. I want to drive my Honda to the moon (238,900 miles). We will see if I can accomplish it.

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If You Hate Your Bank Then I Have Bad News For You at Money Beagle

I have a hard time understanding why people like to complain about banks. Retail banking is one of the most competitive businesses. If you don’t like your bank, just move. With plenty of choices there is no point in complaining, unless you still want their service but just don’t want to pay the price they ask.

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First Anniversary of Barclays Online Savings Accounts and CDs by Ken Tumin at DepositAccounts.com

Barclays Bank is relatively unknown. So is CIT Bank. Both offer better rates on savings accounts and CDs than the better-known competitors Ally Bank and Capital One 360 (formerly ING Direct). There are good reasons Barclays and CIT will stay competitive. Another new entrant TIAA Direct lacks such motivation. It quickly faded into mediocrity as a result.

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Lessons learned from three prospective clients by Michael Zhuang at The Investment Fiduciary

You always learn from others whether positive or negative.

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Can You File An Extended Warranty Claim After A Credit Card Is Closed?

Harry Sit — Wed, 01 May 2013 12:26:00 +0000

My Garmin Forerunner 305 GPS running watch broke. It keeps resetting at random times. I refreshed the firmware. It didn’t help. Raindrops got into it some time ago. That probably messed up something.

I bought the watch in July 2011. The manufacturer has a 1-year warranty. I paid with my Starwood American Express card, which gives extended warranty for another year. I’m lucky it’s still within the 2-year mark.

American Express has a great online claims center for filing an extended warranty claim. The problem is I already closed the Starwood card because I was accumulating more Starwood points than I could use. I closed it before another annual fee would hit. After I closed the card, I removed the card from my online profile. I shredded the physical card. Now I don’t even have the full card number.

Are you able to file a claim for extended warranty after the card is already closed? How do I get the card number if I don’t have it any more?

I called American Express customer service. The friendly rep said yes I could still file a claim even though the card is already closed, but no he couldn’t give me the card number any more because the number is no longer valid. He called the claims department and gave the [closed] card number to the rep there. The claims rep took over and entered the claim for me over the phone.

Normally they would issue a credit back to the card. In my case because the card is already closed, they will send me a check.

Problem solved. I received great service from American Express. This level of service drives customer loyalty.

By the way, the Starwood American Express card is great if you like Starwood hotels (Sheraton, Westin, etc.). The points I redeemed were worth 3.5-4% of the amount I charged on the card, much higher than cash rewards from other cards. My problem is the small towns I travel to often don’t have a Starwood hotel. Otherwise I would keep using the Starwood card.

[Photo credit: Flickr user eirikso]

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Why Investors Don’t Realize CDs Are a Better Deal Than Bonds

Harry Sit — Mon, 29 Apr 2013 12:28:00 +0000

After reading my article last week CD vs Bond Fund: A Case Study, reader TJ asked:

“Why does anyone hold bonds EVER, if CD’s always win?”

First, like many things in life, it’s not all-or-nothing: all bonds no CDs or all CDs no bonds. Even if CDs are strictly better than bonds, there are still reasons to hold bonds instead of CDs.

CDs are typically not available in 401k or 403b plans. If we have another stock market crash, it’s easier to sell bonds to buy stocks for rebalancing. But as I wrote in the previous article which debunked a few myths about CDs, you don’t need 100% of your fixed income money for rebalancing. Usually you only need 1/4 to 1/3 of it. The bulk of your fixed income money can go into CDs.

For people in a high tax bracket investing in taxable accounts, muni bonds are still a better deal than CDs.

For the moment, let’s assume it’s in an IRA and the only choices we are considering are the Vanguard Total Bond Market Index Fund and CDs. In the article last week I showed a 7-year CD bought 4 years ago is projected to be a better deal when it matures in 3 years. Similarly, a 7-year CD bought now is also projected to be a better deal in the next 7 years.

Why don’t investors realize that CDs are a better deal and move from bonds to CDs? I have a few theories, none of which I can prove definitively. They probably all have a kernel of truth. I’m offering these up as possible answers to TJ’s question.

Bonds Used to Be Better

Long term data for CDs are hard to come by. St. Louis Fed has data for 5-year CDs from Bankrate.com since December 2000. The following chart shows the yield of 5-year Treasury minus the yield of 5-year CDs since December 2000. Positive numbers above the red line indicate Treasury yields were higher than CD yields.

Except during the financial crisis when Treasury yields were very low due to flight to quality, 5-year Treasury yield were in general higher than 5-year CD yield by about 0.5%. However I should note that hasn’t been the case since 2011.

Considering that agency and corporate bonds in a total bond market index fund usually have higher yield than Treasury, it’s fair to say that the bond fund had higher yield than CDs most of the time in the past. People remembered that but didn’t notice that time changed. CDs have better yield now.

Bonds Are Better Than Average CDs

The data for CDs in the chart above are for average CDs. If you just walk into a random bank, you are not going to get a rate as good as bond yields. I see Wells Fargo offers a 58-month CD paying 0.5%, a far cry from a 5-year CD from CIT Bank paying 1.75%, a 7-year CD from Discover Bank paying 1.9%, or even higher at some credit unions.

The Internet has made it much easier to find the best CD rates. It could be that the best CDs have always been better than bonds but people just didn’t know where to find them.

Mentally Associate CDs With Short-Term Savings

Bonds are a product of Wall Street. They are traded in the capital market. Bond funds buy, hold, and sell bonds. They are associated with investing. CDs are a retail product. They are associated with short-term savings. People don’t think about CDs when they are investing.

Institutional investors can’t deal with CDs. When they are talking about investing in fixed income, bonds are pretty much the only game. When they mention cash, they mean money market funds, not bank savings accounts or CDs.

In this otherwise excellent web cast from Vanguard, Ken Volpert, head of the Vanguard Fixed Income Group, made no mention of CDs as an alternative to bond funds, as if bank savings accounts and CDs don’t exist.

“And for investors who are sitting in cash, they’re basically earning zero. At least the bond market has given you a couple of percent returns. So if it takes a few years before we get back to normal, you could be losing a few percent a year relative by sitting in cash.”

Sitting in cash is not basically earning zero. If cash means bank savings account, you can get 1% or above 1% at some places. If cash means bank CDs, you can get the same “a few percent a year” or higher.

Want More Liquidity Than Necessary

Even when a bond fund is for long term investing, in an IRA for that matter, it’s fully liquid. You can sell all of it on a whim even though people know they are not supposed to do so and they won’t do so in reality. But they still like to feel they are in control. CDs on the other hand make people feel that the money is locked up, out of their control. If you want to sell you will have to pay an early withdrawal penalty. Nobody wants to hear the word “penalty” as if they did something wrong.

The desire for utmost liquidity for 100% of the money 100% of the time is irrational. When you invest for the long term, the money is already committed. You don’t need to have it all liquid at all times. Getting paid for illiquidity is one advantage small investors have over institutional investors.

Overvalue Simplicity

Having a bond fund together with stock funds all in one account is simple. Investing in CDs would require another account.

So? What’s the matter if I have to create another entry in my Microsoft Money software? I’d rather have a few thousand dollars more in my account than making my software neat.

Unfamiliar With The Ease of Buying

Inertia is a strong force. Even if evidence suggests CDs are better, people like to find excuses saying it would be too much trouble to make the switch. If they never had CDs in an IRA before, they may erroneously think it’s not possible or there are a lot of paperwork to do the transfer. Because people haven’t done it before, they are afraid they would do something wrong. They’d rather stick to the familiar than venturing out for something better.

In fact it’s very easy to buy CDs with money in an IRA at a different institution. You just fill out a form given to you by the bank or credit union. They will get the money transferred over. See the IRA transfer form from Discover Bank as an example. You do it once and you are good for 5 or 7 years. Money is not going to disappear mid-air during the transfer.

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There you have it. Those are the reasons I can think of why people still invest in bonds not CDs. For people who really understand what’s going on, there’s little reason not to use CDs for the bulk of fixed income investments (except munis in taxable accounts). Even for TIPS for inflation protection, we have CD-like I Bonds as a better alternative. To recap,

Bonds and CDs are not mutually exclusive. You can have both.
Bonds used to be better than CDs but no longer.
Bonds are better than average CDs but the best CDs you can easily find are better than bonds.
CDs can be used for long-term investing as well as short-term savings.
You don’t need to keep 100% of your money liquid 100% of the time. Don’t pay for liquidity you don’t need.
Having another account is not going to kill you. It’s good for your bottom line.
It’s very easy to transfer money to a bank or credit union for CDs, even in an IRA.

[Photo credit: Flickr user marttj]

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