Last Updated Nov 10, 2010 11:01 PM EST
The risk of a bond bubble
Interest rates are at a historic low. The current seven year treasury is paying 1.90 percent annually, according to the US Treasury. And with a seven year maturity, this bond's small payment translates to a 6.6 year duration, which is a geometric average of when you get your money back.
The importance of the duration number is its sensitivity to interest rate changes. A good rule of thumb is that the value of the bond will fall by the duration times the interest rate change. For example, a one percent increase in rates would make the value of the bond fall by 6.6 percent, while a two percent increase in rates would make it fall by 13.2 percent.
Thus, should rates suddenly rise by two percent, this bond would have declined in value by 13.2 percent and be worth approximately $86.80 for every $100 invested. Hyperinflation could devastate this bond.
You can hold this bond to maturity, but the opportunity cost of the lower payment is equal to the decline in the value of the bond. Holding to maturity only gives you the illusion of avoiding the loss.
Enter Pentagon Federal Credit Union
Though I recently wrote about four CDs to protect against a bond bubble, only Pentagon Federal still has an attractive rate at 3.49 percent APY, yielding 1.59 percent more than the seven year Treasury. It's backed by the NCUA, a U.S. Government Agency, as long as you stay below the maximum of $250,000 per depositor. Investors can actually get a couple of million in insurance by structuring their accounts.
But the brilliance of this CD is far more than the extra 1.59 percent extra yield over the Treasury. It comes with a Put Option that allows you to sell it back to Pentagon Federal at the approximate price of $96.51 per $100.00. That's because the early withdrawal penalty is the most recent 365 days' interest.
Michael Shafia, Assistant Vice President and Financial Planning Specialist at Morgan Stanley Smith Barney, LLC, was quick to point out that this strategy was paying investors an extra yield for a "putable bond."
How solid is this Put?
There is a lot of chatter on my favorite site to find CDs, DepositAccounts.com, on whether banks and credit unions have the right to change early withdrawal terms. My recent article shows that CD terms are binding but you must read the details of any disclosure.
Pentagon Federal spokesperson, Amy Doane, confirms that the terms of their CD are binding and they cannot change the penalty or early withdrawal terms of existing CDs. The account disclosure does give Pen Fed the right to hold any withdrawal request for up to 60 days.
I don't know whether or not a bond bubble is on the horizon, but I'm more than willing to be paid an extra 1.59 percent to protect against this possibility. And only the small investor can get paid to take this hedge, as $250,000 of insurance is chicken feed to the likes of Goldman Sachs. Opportunities like this seem too good to be true but there is a reason they exist - Wall Street can't make any money from it.
Pentagon Federal typically changes its rates at the end of each month so don't wait too long. To qualify for membership, you may have to pay a one-time fee of $20 to join the National Military Family Association for one year.
DepositAccounts.com further describes the strategy and your actual rates if you cash in the CD early. Founder, Ken Tumin, agrees that the Pentagon Federal Credit Union is the best deal around right now and was a bit surprised they didn't lower their rate last month.
This may be the last great CD rate for a while.
Author's note: I have been a member of Pentagon Federal Credit Union for several years, using this same CD strategy.