Last Updated Aug 31, 2010 6:38 PM EDT
High returns without high risk?
I remember my mantra that, in efficient markets, you can't get higher returns without more risk. Well, the U.S. Government creates a market inefficiency with FDIC and NCUA deposit insurance.
It's this inefficiency, combined with the pricing of CDs by certain institutions, that gives the small investor a rare opportunity to win no matter what direction interest rates move. To be attractive, a CD must have both a top long-term yield and a relatively painless early withdrawal penalty.
Reframing the way you think of a long-term CD
Three weeks ago, I wrote about the best CD in America at Discover Bank. Discover lowered their rates a tad since then, so let's look at another example first - a seven year CD at Pentagon Federal Credit Union with a 3.75 percent APY and one year surrender penalty.
According to my calculations, cashing it out after two years still nets a 1.93 percent annual return on your money, after paying the surrender penalty. That's nearly four times what a two-year Treasury is paying. After this two year penalty, you get a free option to earn 3.75 percent annually for the next five years. And if you leave it in for the entire seven years, the penalty is gone, which is like getting a 3.75 percent bonus at the end of the period.
So don't think of this as a seven year CD. Think of it as a two year CD that pays as high as any two-year CD, and that also gives you this free option to earn much more after two years, as well as a possible one-time bonus after seven years.
If inflation runs wild after two years and rates rise by four percent, withdraw those funds and reinvest at the higher rate. While you will have earned 1.93 percent annually, someone in an intermediate bond fund, with a five-year duration, will have lost a whopping 20 percent based on the interest rate increase. If inflation stays low, you've locked in that higher rate for five more years and will still earn more than the intermediate-term bond investor in U.S. Government securities.
While they have lowered their ten year rate to 3.25 percent APY, Discover Bank still makes my list of one of the best CDs in America. With a nine month simple interest penalty, a ten year CD yields 2.05 percent annually when cashed out in two-years. It offers an eight-year option to earn 3.25 percent annually for the next eight years, and a 2.40 percent bonus by not paying the surrender if held for all ten years. Let's also not forget about that AAA bonus of 0.05 percent annually.
USAA Bank has a seven year "super jumbo" CD for those with $175,000 or more. It yields 3.92 percent APY, with a one-year simple interest surrender fee. That translates to a 2.05 percent annual rate for two years, and an option to earn 3.92 percent for the next five, combined with a 3.85 percent bonus if you leave it in all seven years. Again, the bonus comes from not paying the surrender penalty. Rates are also attractive for lesser amounts.
Perhaps the most innovative CD comes from Ally Bank. Its longest CD is only five years with 2.74 percent APY, but its penalty is a mere two months. That gives a great two year rate of 2.52 percent annually, after the small surrender, and a three year option to earn 2.74 percent annually. In fact, even the one-year cancellation earns 2.29 percent after the penalty. It's a great option for those who think they might need the cash in a year.
A comparison of all four CDs
The chart below compares the four CDs featured. In every case, the two year return is four to five times that of the two-year Treasury, and the five-year return is more than twice that of the five-year Treasury. The way you would read this chart is that a ten year Discover Bank CD, cashed in after five years, would yield 2.82% annually, after the withdrawal fee.
A win-win no one will tell you about
These great CDs exist because no one has the incentive to tell you about them. They don't pay commissions, and any planner charging a percentage of assets can't use these vehicles to get their take. And it's lucky for us that they don't because, if they did, these rates would disappear as soon as advisors steered billions of dollars toward these products.
How to move forward
Always do your own due-diligence and read the full disclosure before opening the CD. Check the current rate as they will change regularly. Stay below the now permanent $250K FDIC and NCUA insurance limits. Make sure your CD is opened at the stated rate. Start at DepositAccounts.com to find the current highest rates today and research the early withdrawal penalty.
Buying these CDs is like being paid to take out insurance against a potential bond bubble. This strategy is a heads you win/tails you win type scenario, if properly implemented. Investing has few opportunities like this. I've jumped on them!