Fri 14 Jul 2006
Now might be a good time to start thinking about a CD or bond ladder for your short-term or “safe money”. With the FOMC still raising short-term rates, long term rates have had plenty of time to move up as much as possible…
Why ladder? Let’s look at three scenarios:
- Rates keep going up
If rates go up, you have CDs maturing every year that you can then turn around and lock in at a higher rate. In the mean-time, hopefully you’re beating your money market rate by investing in the higher CD rate. - Rates stay the same
You’re earning more in a CD than in your money market account. - Rates go down
You’ve locked in that juice 5.5% rate for a 5 year period while your money market yield starts going down as rates fall. Pretty soon your money market is yielding 3% again, but you have a full 200 basis points more in earnings because you decided to ladder. Ideally the yield curve gets back to a normal curve, and you still get decent rates when you roll forward into the new 5 year CD each year.
Oddly enough, with the current rates available on CDs, you’re losing very little yield on the shorter-term CDs if you’re just starting out on a ladder.
July 14th, 2006 at 9:39 pm
So what would be your ideal laddering scenario if you had, say, $10,000 of idle money that you wanted to put into a laddering setup? We discussed this a while back and I remember posting several scenarios (see next 2 comment posts)–how would you modify these proposals?
July 14th, 2006 at 9:41 pm
This one was from Quicksilver on 11/16/2005:
“I think you’ve got the right idea to get into some type of ladder if your expectation is that interest rates will change over the next year. I’d go for dividing your money into 5ths and putting 1/5 into 6, 12, 18, 24, 30 month respectively. Buy a 30-month whenever one level expires, giving you an expiration every 6 months. If you want to play a interest timing game (you really feel confident it will rise over the next year then stop or fall thereafter), I’d keep rolling my money in 3-month T-bills until I think rates have peaked, then lock it in with a 2-year T-note or long term CD. You also might want to find out when the Fed meetings are and try to time your expirations around them. I’d tread lightly with option 3 as it could expose you to more risk and fees than necessary and short-term savings should be as risk free as possible.
But the fact is that interest rates are improbable, if not impossible, to predict no matter what the Fed is saying now, so laddering is better than building around some sort of one directional expectation that might not come to pass.”
July 14th, 2006 at 9:44 pm
This one was from Jason G. on 11/16/2005:
“I agree with Quicksilver, with a catch (and a counter-argument to the catch). What follows is a theoretical approach to cd laddering. For safe money, I?d still go with a cd ladder instead of any other strategy.
CD laddering (and its brother bond laddering) is a good, sophisticated technique to improve the yield on your savings or fixed income investments.
The drawback right now to laddering is the way that the yield curve is flattening. I went and did a quick check on CD rates (from ingdirect.com) ? 6 month cd = 4%, 60 month cd = 4.85%.
While the 0.85% difference is 22% more than the 6 month rate, you have to think about the lock-up period for the extra return. (Side note ? penalties for breaking a cd are small.)
The best thing to do is to look at the yield curve and figure out the sweet spot. Because I?m having trouble with excel, I had trouble graphing all the rates available… instead here is a chart of the 1, 2, 3, 4, and 5 year yields at ING.
[chart didn’t import well…sorry!]
Looking at that chart, it seems like the 2-year is at the peak of the arc. Going for a longer duration than 2 years doesn?t seem to be worth the additional yield. Ladder up to 2 years so that you don?t
However, let?s bring out the ?lies, damn lies, and statistics? truth perspective… here?s the chart again with a ?zero duration cd? of 3.5% for ING?s savings/money market account:
[chart didn’t import well…sorry!]
(Axis shifted, 1 = 0 duration, 2 = 1 year, 3 = 2 year, etc.)
Well now, that makes the whole chart look a little different, especially when the y-axis goes all the way to zero. Do I want to take a 2-year lock-up period to reach for that extra 1.15% in yield? Do I want to take a 5-year lock-up period to reach for that extra 1.35% in yield? Not as much…
Ok, so it seems like we can take a lot of duration risk for little gain… game over, right?
Now a counter argument. What happens if interest rates fall from here? (Don?t laugh; there is a recent historical example: Japan in the 90s.) What happens if Greenspan/Bernanke are forced to start cutting rates and yields come down across the entire yield curve? (The curve can stay flat and still go down.)
By laddering properly, you lock in the current long-term rate, even as rates fall. That?s the downside to not laddering when rates are falling. If my savings account rate falls down to 1%, I could have had money yielding 4.65% for two more years ? instead I languish with a measly 1% return on my money.
So, I?ve taken the typical economist position and said, ?it depends?. But what am I doing with my money?
I don?t think rates are done rising… I think Greenspan (and Bernanke after him) will keep raising rates for at least another 4 months. (Caveat: this ?prediction? is subject to change any time I read the newspaper or look at the stock market.)
Important question/assumption: Will money market rates keep moving up with the fed funds rate? Probably not. Will the long term rates go up from here? I?m guessing it will, but it?s not a clear-cut answer (variables: foreign central banks, pension funds, institutional investors, retiring baby-boomers, etc).
The important factor for me is the risk/reward tradeoff. The risk if I?m wrong is that rates drop –> I make less in interest. The reward if I?m right is that rates rise –> I make more in interest (either now in my money market account or in the cds that I start to ladder when rates are higher). I?m willing to take that risk, based on a variety of factors, not least of which is my own judgment.
At 4.85%, or even at 3.5%, compounding doesn?t have enough interest to really gain traction. Even with 5% yields, it takes approximately 14 years for your money to double. The reason I?m trying to get yield is to get the benefits of compounding on my side. If I can?t get enough of that benefit, even with a 5 year cd or a 20 year t-bond (5.32% yield), I?m going to hold my cash and wait for better opportunities.
Back to reality… if you?re looking at your ?safe? money, a cd ladder is a good idea. There are drawbacks like any strategy, but the downside is limited. In the absolute worst case, interest rates triple… you pay the penalty for cancelling your current 5 year cd and the interest on your new 5 year cd more than makes up for the penalty.
Hope you enjoyed the random walk through my thought processes…
July 14th, 2006 at 10:32 pm
Well, apparently my guess back in November was correct… the Fed kept raising rates.
Now, what would I recommend? First, thoroughly investigate the penalties if you do an early withdrawal, make sure there aren’t any hidden fees. Look at minimums to make sure you don’t miss anything… Also look for promotions that will get you extra benefits from opening CDs.
Then, assuming $10,000 to invest, I’d probably ladder with $2k for each 1 year increment. If the 6 month CD is higher than a 12 month, you might consider going shorter and risking that rates drop when a 6 mo. CD matures.
This could either be your emergency money (money you don’t plan to spend unless you have an unforseen emergency), or it could even be the fixed income portion of your asset allocation.
CD ladders are rarely a bad idea… even if you’d started laddering back in November (a less-than-optimal time according to me back then) you would have still outperformed your money market account.