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Subject:  The Alternatives to PenFed's CD? Date:  9/19/2010  3:02 PM
Author:  charliebonds Number:  31497 of 35593

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)