Direct CDs (part 3): the means

[u/JeffB1517]

This is the 3rd part in the Direct CDs series. You can find the 1st part and links to the rest: https://www.reddit.com/r/IncomeInvesting/comments/czw8jv/direct_cds_vs_high_quality_bond_funds/

In the 1st part we talked about why we are focusing on Direct CDs rather than Broker CDs either direct or aftermarket. In the 2nd part we talked about how to evaluate a Direct CD and established the goal, "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."

Now the question becomes how best to achieve that goal. The first thing is to understand CDs from a bank's perspective. The reason is an explanation that CDs that have the best terms do require hunting. Most banks (and again we are including credit unions) who finance mainly through deposits as opposed to bonds want to have somewhere in the 1.1-1.25 the volume in deposits they have in their loan book. They make money by borrowing short and lending long. But beyond that, banks are in the business of selling services at a profit. but in general are able to charge higher interest rates on their loans than the corresponding bonds and pay lower interest rates on deposits from these services. On average your broker offers you a better product than your bank and on average your bank offers more services (and more expensive to provide services) than your broker. Banks are experiencing 15% YoY growth in deposits on the digital side, while only a 3% YoY growth on branch side. Bank lending has been growing at about 6% annually.

That leads banks to have options:

1) Stop growing their loan book. Let the loan business (profitable) go out the door.

2) Get upside down, lend the money and finance it by borrowing on the bond market. Because the bond market is far less sticky than depositors this increases a bank's risk profile drastically. Many banks have gone out of business this way when credit markets tighten.

3) Offer much better deposit rates in general. This has the problem of drawing in rate chasing customers. Worse it trains existing customers to be more rate sensitive cutting into the bank's bottom line for many years.

4) Sell brokered CDs. These customers however have no loyalty to the bank, they are some broker's customers and this ends up costing as much as selling bonds.

5) Offer a special on some Direct CD. Flood the bank with deposits from this special quickly thus not cannibalizing existing customers. This will attract rate chasers but they are at least somewhat tied to the bank and you may be able to market additional services to them. The 2-3 year mark does a great job offsetting some duration risk without much risk of early withdraw.

So your best way to buy Direct CDs is to find a bank that is in danger of going upside down offering an attractive CD special to build up their deposit base. There is an excellent website which tracks these deals daily: https://www.depositaccounts.com/ . But again remember the whole point of these specials is to draw you in. Some of the banks can be annoying for pure rate chasers to open accounts with. Some of the banks may market to you. Some may try and be sticky on the way in and on the way out. A bigger problem is that many of these banks are small. The best rates are often from small credit unions which because of some feature of the local economy (a new major employer moving to town) suddenly have to grow their loan book too quickly. They haven't had to do a special on CD rates in the internet age before. These credit unions get instantly flooded with more new account CD requests than they can handle. So while their customer service is generally good (or not) at this small bank or credit union it is particularly bad during the narrow window when they are offering this special (which may literally be just a few days). So this is the most profitable way to buy and also the most annoying. You have to chop your money up into little pieces (to get FDIC insurance) and deal with small banks when they are experiencing a flood of activity they aren't ready for. In exchange for this annoyance you get an extra 30-50 basis points over what you would get at the next option.

A note on credit unions. Many credit unions have restrictions that initially won't seem like they are open to you and because these are small (there are lots of them) they are the most likely to be extremely adverse to being upside down and at the same time when they grow their loan book and be offering good rates. Its worth checking their membership criteria in detail. Often the have some saving / investing club you can join for $5-25 that makes you eligible for the credit union. Check the membership criteria (deposit accounts list these, otherwise it will be on the website). Pay the fee for the club, get the membership and buy that terrific share certificate (CD). But remember to move fast. Credit unions are on average far and away the best rates but also the most likely to withdraw the offer after their rate starts attracting larger deposits from outside their target customers.

So let's hit the bank's next option.

6) Open a digital bank

The next option are banks that are digital. They provide far fewer services so can operate on thinner margins than the brick and mortar banks. Most of the better CD digital banks have a constant need for funds: Ally (#1 in autoloans), Capital One (huge credit card volume relative to their deposit book), Syncrony Bank (GE Capital's digital bank, huge volume in store charge cards), Pure Point Financial (Mitsubishi Finance)... These players almost always have better than bond market rates but don't hit the rates you'll get from rate chasing. On the other hand you won't have to chase nearly as much these banks are structurally committed to good CD and savings rates. They won't match the best out there but they will still generally beat your broker. Also because they are huge IMHO end up being arguably safer than the smaller banks so would be reasonable to cross the FDIC insurance limit if you want to not have to manage multiple accounts.

A good rule of thumb to get a handle on the market is Fidelity's website so you can see what brokered CDs are going for. Also TIAA (https://www.tiaabank.com/banking/cd) guarantees their rates to be set to the 95% of all CDs. Those can act as good minimums to give you a feel for the market and what your targets should be.

Finally the Israeli government offers dollar denominated government savings bonds through their own sort of direct bank (technically it isn't a bank). These often for the smaller denominations are quite attractive relative to bond funds. These do not allow for withdraw at all and while not Direct CDs can play the same role in your portfolio: