If you want to earn more on your “safe” money than you can get from buying certificates of deposits directly from a bank, you might want to consider something called brokered CDs.
Although going directly to banks to buy high-paying CDs with easy early withdrawal penalties is still my core strategy for safe-money investing, I’ve started adding brokered CDs for my clients’ portfolios and my own.
Brokered CDs are certificates of deposit sold through brokerage firms such as Fidelity, Schwab and Vanguard. They are issued by banks, so your money is invested in the individual bank rather than the brokerage firm you purchase through. They have pretty much the same FDIC insurance as CDs bought directly from banks, with a caveat I’ll discuss shortly.
They can be bought on the primary market (where the brokerage sells you a CD directly from a bank) or the secondary market (where you buy, through the brokerage, an existing CD that someone else has sold). These brokered CDs are securities and trade like bonds. I’ve found that the best yields are on those bought in the secondary market and tend to be longer-term CDs.
For example, as of this writing, Vanguard was offering a CD from Goldman Sachs Bank on the secondary market yielding 3.12 percent, and maturing on July 7, 2024, or roughly 9.2 years. Once the commission is taken into account, the CD yields 3.11 percent. The CD is non-callable, meaning the bank can’t decide to cancel the CD and pay your money back before maturity.
By comparison, a 10-year Treasury bond was yielding only 2.07 percent, though interest is not taxed by the state. In fact, even AAA 10-year corporate bonds were yielding only 2.71 percent. And don’t forget that both General Motors and Eastman Kodak had AAA ratings before their bankruptcies.
The CD is also attractive when compared to bond funds. Take the Vanguard Total Bond Fund ETF (BND), for instance, which was yielding 1.89 percent. Only 64 percent of its underlying holdings are backed by the U.S. government and government agencies.
Don’t make the mistake of thinking there isn’t interest rate risk with a brokered CD just because it has a fixed maturity. Like a bond, you stand to lose money if interest rates rise and you need to sell before the CD matures.
Keep these five things in mind if you are going to buy brokered CDs:
- Stick to a reputable, well-known broker. Depositaccounts.com offers some valuable advice on buying secondary CDs.
- Don’t buy a callable CD. If rates stay low or fall even more, you won’t likely get that attractive yield for long.
- Make sure you don’t need your principal back before the CD matures. Because these CDs trade like bonds, you don’t get the easy early withdrawal penalty as when CDs are purchased directly from banks. In addition, you will pay a commission and a spread if you later sell your CD in the secondary market. Though no data appears to be available, a spread of 1 percent could easily occur, meaning the brokerage firm will buy your CD back at 1 percent less than its selling price to someone else.
- Don’t let the interest payments accumulate in cash. Brokered CDs don’t allow you to reinvest interest in the same CD, and most brokerage firms pay you a whopping 0.01 percent annual yield on your cash. You can put the cash in a no-load mutual fund if no commission is charged.
- Never go above the FDIC insurance limits, which are $250,000 for individual accounts and $500,000 for joint accounts per each bank. By titling accounts correctly, however, it’s easy to get much more FDIC insurance.
My take is that this is a reasonable strategy to earn above-market returns with at least 98 percent protection against default. Though the longer maturity does have more interest rate risk if rates rise, keep in mind that economists have been forecasting rates horribly for decades. Also, if you use longer-term brokered CDs along with the original direct-from-bank CD strategy having only short-term interest rate risk, you end up with more of an intermediate-term portfolio giving yields that big institutions can only dream of.
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