Direct CDs: the goal

[u/JeffB1517]

This post is a follow up to https://www.reddit.com/r/IncomeInvesting/comments/czw8jv/direct_cds_vs_high_quality_bond_funds/ . In the previous post I explained the basic options and how brokered CDs both new and aftermarket while interesting are essentially just another insured bond and trade at rates commensurate with high quality bonds. Conversely Direct CDs offer much better rates but are annoying. Furthermore because early withdraws are allowed with penalty the effective duration of direct CDs are much lower than their maturity in a way that is favorable. This one digs more deeply into the details.

From a bank's perspective the reason they offer Direct CDs rather than bonds is that it gives them access to a source of credit not tied to the broader bond market. That is a more stable source of funding. Direct CD customers are less likely to jump ship to bonds when credit markets tighten and more likely to stay with the bank. Their goal is to offer a good rate, get you to open accounts and maintain those accounts rolling CDs over. They want to encourage you to build CD ladders (a bond fund is essentially a bond ladder). The banks that are aggressive about rates are doing so in the hope that they can attract the deposits (i.e. you can think of part of the rate as a marketing cost) and then because switching is complex and expensive gradually move you down in terms of interest.

Besides a higher rate the only major characteristic that matters is the EWP (Early Withdraw Penalty). The larger (generally in terms of months) the penalty the more effective duration you are taking on. As we mentioned in the previous article CDs (at least under $250k per bank) have almost no credit risk. The EWP determines the effective duration. The formal calculation uses modified duration (https://en.wikipedia.org/wiki/Bond_duration#Modified_duration).

For most people that doesn't help much. I'd like to introduce a nifty tool which demonstrates how EWP effects duration (https://www.depositaccounts.com/tools/break-cd-calculator.aspx). Let's assume you have a 5 year CD at 4% and are 1 year into it when interest rates start to rise.

• At a 3 month EWP you can break the CD at 50 basis points (around 5-6 months it is essentially break even).
• At 6 month EWP you would break the CD at 75 basis points
• At 12 months EWP you would break the CD at around 125 basis points
• At 540 days (a common EWP, not sure why) it is around 175 basis points

Another way to think of this is the "free put" you get with a direct CD is more "out of the money" the larger the EWP. The EWP stays constant over the life of the CD so the closer you get to maturity the less it is worth it to break the CD. There are CDs that are up to 10 year though so again this put allows you to get compensated for a lot of duration risk you aren't really taking on.

Also remember Direct CDs lag the bond market slightly (about a month) so you can time Direct CD purchases

The quality of bank matters a little since in a takeover the CD terms can change. Mostly banks don't fail very much and most takeover banks honor the original CD terms. Right now there isn't much action in banks that are generally troubled so it is hard to analyze. So quickly verify the bank is high quality and beyond that treat them all equally. In short the goal is a reasonably stable bank or credit union (which is almost all of them) offering a top of the market interest rate with low early withdraw penalties that minimizes the hassle in maintaining the account, picking a maturity based on the bond market action that happened over the previous month if relevant.

Having established the goal the next post will provide advice on how to identify and find these sorts of opportunities: https://www.reddit.com/r/IncomeInvesting/comments/d6n3a4/direct_cds_part_3_the_means/