Bank CDs, not funds, currently offer a better bang for your buck.
A version of this article will be published in the June 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.
There were 31 short-term bond exchange-traded funds with a combined $60.9 billion in assets as of the end of May. They offer yields ranging from nil, in the case of SPDR Barclays 1-3 Month T-Bill BIL, to more than 2%, in the case of AdvisorShares Newfleet Multi-Sector Income MINC. The biggest, Vanguard Short-Term Bond ETFBSV, yields a little more than 1%. A few, like PIMCO Enhanced Short Maturity ETFMINT and iShares Short Maturity Bond NEAR, step into the gap created by tighter money market fund rules.
Which one is best? None. Low policy rates, competition among banks for retail business, and tighter regulations have created an unusual environment where the highest-yielding bank CDs dominate virtually all short-maturity bonds and offer vastly superior risk-adjusted yields to most intermediate-maturity bonds.
As of this writing, Synchrony Bank and Barclays offer five-year CDs yielding 2.25%. There is no other fixed-income investment that I know of that offers the same yield for equal or lower risk. (Synchrony Bank is a subsidiary of General Electric GE and was until very recently called GE Capital Bank, so we're not dealing with a fly-by-night operator here.)
Bank CDs, as you know, are insured by the FDIC up to $250,000 and are backed by the full faith and credit of the U.S. government. Their credit risk is nil.
Their duration is 1.7 years at most. That's not a typo. CDs can be thought of as putable bonds, where the lender has the right to demand principal back at any time, minus a modest penalty, regardless of what interest rates do. Barclays imposes an early-withdrawal penalty of 180 days' worth of interest; Synchrony Bank imposes a 270-day penalty. These penalties amount to 1.1% and 1.7% of principal, respectively. Furthermore, the penalties are capped. If interest-rates spike 10% overnight, you'd be hit with double-digit losses on all but the shortest-duration bonds, but your CDs will lose almost nothing, and you'll have the option to reinvest at these higher rates. The drawback is if interest rates fall, a bank CD's redeemable value does not rise. However, it's still intrinsically more valuable because of its above-market yield.
Keep in mind I'm talking about bank CDs. Brokered CDs, which you buy through a broker like Fidelity or an advisor, are rarely putable and often have fees attached to them.
There is no better deal out there in fixed income. To get a 2.25% yield in Treasuries, you have to buy seven-year bonds, which have durations of 6.5 years. To get a 2.25% yield in investment-grade corporates, you need to buy four- to five-year bonds, which have durations of almost four years, plus the nasty tendency to fall in bear markets.