Intermediate Term CDs Have Become Significantly More Compelling than Even the Highest Quality Municipal Bonds

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Historically, the wealthy and near wealthy have been prompted by brokerages like Morgan Stanley and Merrill Lynch to eschew CDs in favor of high grade municipal bonds. While the advice of the major brokerages has a self-serving function (they generate commissions on their clients’ municipal bond trades, but lose assets under management when a client withdraws cash to purchase a CD), it has also been very sound advice. The competitive market in CDs and rapid decline in long term interest rates has now made intermediate term CDs much more attractive.

As a general proposition, an investor who has carved out a sum of cash (say, $200,000) that they have relative certainty that they will not need for an extended length of time and do not want to risk, would give careful consideration to putting the money into a municipal bond. Buying a long-term municipal bond that is triple tax-free produces interest that can be especially valuable for those in higher income brackets. So long as the investor purchases only high grade municipal bonds insured by Berkshire Hathaway, the biggest risk to a municipal bond purchase is that interest rates rise and the value of the bond declines. Most municipal bond purchasers get comfortable with interest rate risk by accepting the notion that if rates rise, they will just hold the bonds to maturity. While purchasers today may get comfortable with the notion, they also need to recognize that municipal bonds ordinarily trade according to 10 year bonds rates. With those rates running around 2.40% and Bloomberg’s 10 year municipal bond index running at 2.20%, municipal purchasers in high tax states like New York, Massachusetts, Illinois or California are unlikely to find high quality 10 year munis yielding over 2% to maturity.

This same investor now has the option of putting the money in a 5 year CD. While the CD does not have the same tax benefit (interest is taxable local and federally in the year of accrual), the rates are slightly higher (the best 5 year CD rate is now 2.30%) and capital invested in a CD is not at risk up to FDIC limits. Most importantly, the interest rate risk is simply much lower than that inherent in buying municipals with 10 year interest rates at such low levels.

This chart demonstrates the spread between the 10 year Treasury rate and the best available 5 year CD rates over the last five years. With the rates crossing for first time in a year, and for the first time since higher rates became a real prospect in the US's immediate future, CDs look attractive.

There are at least three reasons why the interest rate risk in the intermediate term CD may always be lower which are especially relevant in the current environment with the prospect of higher rates. They are as follows:

1. A five year CD has a five year interest rate risk. If you apply the same notion that the works case scenario is that you hold to maturity if rates rise, a five year CD is always going to have a much shorter time horizon to getting your principal back than a 10 year municipal bond.

2. Most CDs allow breakage and a return of your principal with certain penalties. The penalties for breaking a 5 year CD among the major issuers of online CDs range from 6 months to 15 months of interest. If, for example, the US were to return to normalized interest rates in 2015 or 2016, you can pay the penalty and get your principal back. The municipal bond doesn’t have breakage provisions and you would be faced with a huge loss of principal if you were to need to sell. Tip: Always check the breakage penalty before you buy a CD.

3. Some online CDs allow for the penalty-free breakage of a CD upon the death of a holder at the request of the heirs, beneficiaries or executor (you may wish to ask before opening an account). If you were to die holding a municipal bond at your death, the executor or executrix of your estate may need to liquidate the bond and the value will depend on interest rates on that day and the liquidity of the bonds. Again, if interest rates were to return to their pre-2008 levels, your estate will recover significantly less than the price you paid for the municipal bonds.

Even if you don’t plan to need your money, life throws curves. Municipal bonds bear interest rate risk. With municipal rates at very low levels, you may be better off handling the interest rate risk by buying a 5 year CD.

See the best 5 year CD rate here.

Ari Socolow
Ari Socolow: Ari Socolow is the Chief Economist and Editor-in-Chief at BestCashCow. He is particularly interested in issues relating to bank transparency and the climate crisis. Since co-founding BestCashCow in 2005, Ari has been frequently cited in the media as an expert on local and national savings accounts, CD products, mortgage and loan products and credit card rewards products.

Today's Highest Online CD Rates

Bank Product Term Interest Rate (APY)
Charles Schwab Bank, SSB 1-Year 5.40% APY with $1,000 minimum
Finworth, a division of InsBank 1-Year 5.38% APY with $50,000 minimum
TotalDirect, a division of City National Bank of Florida 1-Year 5.35% APY with $25,000 minimum
Dollar Savings Direct, a division of Emigrant Bank 3-Year 5.00% APY with $1,000 minimum
M.Y. Safra Bank 3-Year 4.70% APY with $500 minimum
First Internet Bank of Indiana 3-Year 4.66% APY with $1,000 minimum
First Internet Bank of Indiana 5-Year 4.55% APY with $1,000 minimum
BMO Alto, a division of Bank of Montreal Harris 5-Year 4.50% APY with no minimum
Department of Commerce 5-Year 4.34% APY with $500 minimum

See More Online CD Rates →

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