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Subject:  The Alternatives to PenFed's CD? Date:  9/19/2010  3:02 PM
Author:  charliebonds Number:  31497 of 35367

PenFed is offering a 10-year, 5% CD to selected clients. I happen to be one of them, for reasons only they know, since the CD is only $5k, and I’ve consistently yanked every penny out my accounts with them the instant I found a better place to park the money. But right now, 5% might be attractive. So that is the subject of this post. On a risk-adjusted basis, can I do better with the money elsewhere?

First, it needs to be pointed out that the coupon-rate on that CD is something in the neighborhood of 4.89%. The 5% APY is achieved because coupons (aka, the monthly dividends) will be re-invested. Secondly, it also has to be pointed out that taxes will have to be paid on those dividends, probably on a quarterly basis if one is receiving a lot of ordinary income such that making quarterly, estimated-tax payment at both the fed and state level has become necessary. Thirdly, it has to be pointed out that the principal and interest returned at the end of the 10-year holding period will have been degraded by whatever inflation-rate has obtained. Fourthly, if you break the CD, you will forfeit a full year of interest. Therefore, while it might look at if a nominal-gain of 5% would be possible, the reality is that loss of –3% or so will be achieved by buying the CD. YMMV, of course, depending what on your combo tax-rate and your personally-experienced rate of inflation will be. But the prudent bet is that a loss will be suffered. That is not to say that the loss should be avoided. The alternatives might be worse. So that’s what needs to be investigated. Can the money be put to work elsewhere with less risk and/or greater reward?

If the effective coupon-rate is 4.89%, then any principal-protected instrument offering a higher rate over the same or shorter holding-period should be favored. Trying to predict the direction of interest-rates is a fool’s game, no matter the necessity of doing so. Depending on which economist you read, rates will remain flat for the rest of this decade, or they will be rising soon. But what can be known with certainty is where interest-rates are today on the 10-year Treasury note and where they are on those top-tier, agency bonds that that are exempt from state taxes. So that’s the relevant calculation. If you know you can get a 4.89% coupon-rate from buying a 10-year, PenFed CD, and your marginal, state-income tax is 5%, then you ought be willing to a state-tax-exempt treasury, agency, or equivalent that carries a 4.65% coupon provided that you can re-invest the coupons at the coupon-rate. It will be very unlikely that you can. But if a zero is bought, then the re-investment problem goes away. But according to E*Trade bond-search engine, currently, there are no 10-year (or less) treasury zeros offering 4.65% (or better), nor any agencies. So, scratch those two asset classes.

National munis might be another approach. Let’s assume your marginal, federal-tax rate on ordinary-income is 20%. To match PenFed’s 4.89% coupon rate you’d only need a current- yield of 3.9%, right? So that becomes the search game. Can I find a well-rated and insured muni (any state) with at least a 4% yield (to accommodate commissions) and a 10-year (or less) holding-period? In fact, Zions Direct (which allows filtering by parameters such as “insured”, which E*Trade does not) will return a list of 88 such bonds, the bulk of which –-predictably-- are California issues, and many of which are offered only in round lots. But the output of the search engine isn’t “None”. So that might be a viable approach to finding an alternative to buying PenFed’s CD. If credit-quality can be assured, and if the minimum purchase isn’t onerous, then buying munis instead of CDs might be a viable path, especially if the muni is also state-tax exempt.

A third path might be corporate bonds where the task of determining credit-quality will actually be a lot easier providing that one is comfortable doing one’s own credit analysis. Rising prices have depressed yields. But running some searches is worth one’s time.

A fourth path might be dividend-paying stocks. If I’m remember right, either an article in this week’s Barrons (or similar) reported that there are currently 565 stocks offering a dividend of 5% or better. According to other sources, e.g., FinViz’s stock-scanner, there are only 390 stocks that offer over 5%. But, still, that’s a lot of choices, some of which might merit buying.

The paths I’ve listed so far (and there are many more that could be identified) have this in common. “Easy and lazy” is going to lose you money. Your knowable and predictable loss (in terms of purchasing-power) from buying PenFed’s 10-year, 5% CD will be about -3% if current inflation-trends and tax-schedules persist. However, to the extent that you are willing to do a bit of work to investigate what your alternatives might be will also be the extent to which you might be able to turn that predictable loss into a possible gain.

Good hunting to one and all, and sincere congrats to you if you do decide that rolling really is your best choice, all things considered. The purpose of this post isn't to talk you out of rolling, but to urge that you to make a fully-informed decision, so that you know why you will be losing money (but possibly avoiding a worse fate) or how and why you might be enjoying a better one. In the long run, what you decide won't much matter. But taking this opportunity seriously is an opportunity to develop and practice skills that makes the next decision easier and, hopefully, a better one. Investing is a practical art, no different than cooking or fishing. You learn how to do it by doing it, and you learn how to do it well by doing it well, where what is meant by "well" is for you to decide.

Me? I'm not going to roll, because I'm willing to bet that I can do better elsewhere, or that what I'll learn in the process will be worth the effort and price. And now I really am out of here for a couple of weeks. I've got to finish up a 6'6" 2wt I'm building for my daughter. I want to get in a couple more days on the water myself before the season closes. And I've got to figure out where to park the funds that will be coming to me from my 6% CD maturing at PenFed.

Tight lines. Trade well.

Charlie
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