Dear Dr. Don,
I started a five-year laddered certificate of deposit portfolio on May 26, 2011. I put $200,000 in each rung of the laddered CD. All the deposits are insured by the Federal Deposit Insurance Corp. My question is: Should I roll the first rung's $200,000 into a new five-year CD when it matures or invest that money into something else? The CD portfolio represents 50% of my investable assets. I'm retired and use the interest income for living expenses. I plan to leave the principal to my son.
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Over the years, my financial adviser has made suggestions I did not agree on, so I did not invest in them. He wanted me to invest $1 million last year in municipal bonds. When interest rates go up, bond prices fall. I told him I don't trust (Federal Reserve Chairman Ben) Bernanke not to raise interest rates on a whim. So what would you recommend I do?
-- Ursula Ultra
The idea behind a laddered CD portfolio is to try to avoid market-timing issues and to reinvest maturing CDs into the longest maturity on your investment horizon, in your case, a new five-year CD. That's hard advice to follow when the highest annual percentage yield reported on Bankrate for a five-year jumbo CD is 1.75%, and the highest reported yield on a one-year CD is 1.15%.
As I reply to your letter, the 10-year U.S. Treasury note is yielding 1.5%, just off its lowest yield ever of 1.44%. Europe is having currency problems with the decline in the euro, causing a flight to quality to U.S. Treasury securities. That's helping to push down interest rates, meaning it's not a great time to invest in bank deposits.
Municipal bonds normally yield less than Treasuries because the interest earnings on munis are not taxed at the federal level and may not be taxed at the state or local level either, depending on the bonds you own and where you reside. Also, municipals' credit risk is different from Treasuries, and credit risk does play a role in these yield relationships.
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But lately, with investors flocking to Treasuries, munis have been the ones with higher yields. If the municipal yields revert to a more normal relationship when interest rates head higher, then investing in munis provides some price protection versus Treasuries.
I'll agree that you shouldn't blindly follow your investment professional's advice, especially if you aren't comfortable with it, and you're right that bond prices go down when interest rates go up. However, taking your investment professional's advice last year and moving into municipal bonds likely would have beaten the investment returns from your CD ladder, partly due to the longer investment horizon than your CDs, which have an average maturity of 2½ years.
You're right that the longer horizon on a muni portfolio would have exposed you to price risk from rising interest rates. But the choice of municipals usually would provide some protection against price drops from rising rates because of the yield spreads between Treasuries and municipals.
I'd love to recommend Treasury inflation protected securities, or TIPS, but the prices have been bid up on these securities to the point where they just don't make sense, at least not to me.
You don't say how the other half of your portfolio is invested, but take a look at the overall portfolio and how it's meeting your income needs in retirement. Do you need to increase your portfolio's yield to meet your need for income, or is it throwing off enough in interest for you to live comfortably? If the latter is the case, then it's hard to argue that you should chase yield and give up the security of your laddered CD portfolio.
One of your other investment goals is to have your son inherit the principal. The CD ladder, considering taxes and inflation, is losing purchasing power. What's happening with the rest of the portfolio? Work with your investment professional to manage the twin goals of retirement income for you and a financial legacy for your son.