It's a query that's been gaining popularity among advisors and their clients lately: To CD or not to CD? And it didn't emerge in a vacuum.
Over the last decade, interest rates and the corresponding returns on investments keyed to them have been so low that few have used them for anything more than safely preserving capital. But with the Federal Reserve's aggressive rate hikes over the past 18 months, returns on "safe" cash-like investments — including certificates of deposit — have increased.
At the same time the bond market, the traditional diversifier to equity risk, had one of its worst years ever in 2022, making the safe returns of CDs seem even more attractive. As a result, many advisors are now exploring using CDs, Treasury bills, or two-year Treasury notes to replace virtually all fixed-income positioning.
So what's an advisor to do? As always, there are no one-size-fits-all answers, but I'd like to offer a little context about the bond markets and suggest questions advisors should ask clients who might benefit from CDs and money market instruments in the current environment.
How bad have bonds been, really?
Really, really, historically bad. The Bloomberg U.S. Aggregate Bond Index was down an astonishing 13% in 2022, the worst year since 1926 (the second-worst year in this period, 1969, saw bonds down 3.3%). And the stock market was down as well last year, by 18% — the seventh-worst year in that same period.
However, if you were to plot stock and bond market performance from 1926 to 2022, you would see that last year was an extreme outlier. It's also worth noting that bonds have historically been down less than stocks, with bonds posting positive returns in 86% of the years tracked, with stocks at 73%.
Also consider that, historically, bad bond years don't predict a bad return the following year. After 1969's negative 3.3% return, 1970's return was up 17.4%. And in 1994, the third-worst bond year — down 2.9% — was followed by a positive return of 18.5% in 1995. Bond returns have been decent so far in 2023, with much negative investor reaction a result of 2022's poor returns. These statistics constitute neither a promise nor a prediction but it should give investors pause when considering bailing on bonds based on one bad year. Investors do not get the long-term average return without being invested over the entire cycle.
What does that mean for CDs and money market instruments?
CDs and short-term investments have always had a place in portfolios where loss of principal is not an option. The fact that these products are currently offering such relatively attractive returns is a huge positive for those looking to park cash or have a near-term need for the money.
If you and your client are thinking about moving money into these investments, here are four questions to consider:
What is the time horizon?
If the time frame is zero to around 36 months, CDs and T-bills are attractive investments even without the current elevated returns. A short holding period often requires certainty and/or the need to not lose any principal. If your client has money languishing in a checking account (or stuffed under a mattress) consider such instruments sooner than later.
Does the desire for certainty sacrifice more attractive returns?
By locking in a known return today, investors may miss out on the potentially attractive returns that an actively managed process may be able to exploit. Other areas of the fixed-income market are offering yields that are often more attractive than cash-like investments. Additionally, investors only earn the long-term average returns by participating across the entire market cycle. Actively deciding to opt out of these opportunities may reduce long-term returns.
What are the tax implications?
Income from CDs is typically taxed at the client's highest tax rate (the same is true of most bonds). Compare the after-tax return for any money you're moving into CDs with that of income strategies that incorporate qualified dividends, long-term capital gains and/or municipal bonds.
What's next?
Interest rates change, and given the historic speed and magnitude of rate increases over the last year and a half, it sure seems we are closer to the end than the beginning of Fed rate increases. If you're moving money into CDs or comparable investments to get these high rates, and the money will not be needed as cash after maturity, you may need a new plan as you probably won't get these same returns from CDs years down the road.
In short, advisors should do what they always do: consider the long term and consider a client's goals. What's happening in CDs is certainly good news for investors who need these tools but they aren't a panacea, and there are other options to consider that may better fit your clients' needs. So while "maybe, sometimes" isn't the most exciting answer to the question "to CD or not CD," it happens to be the right one.
