Looking through your old compact disc collection can be nostalgic. The cover photo on your favorite CD or a few bars of a summer song can transport you back in time to what seems like a better, simpler place. Similarly, many investors with cash to invest turn to what they remember from a simpler time before the financial crisis when liquidity was plentiful – bank certificates of deposit (CDs).
However, both the music industry and the financial markets have evolved in the past decade and offer far more choice today. Audiophiles can hear digital music almost anywhere anytime. Similarly, investors’ choices for managing cash and short duration assets have evolved to include actively managed ultra-short-term and short-term fixed income strategies, which can offer greater liquidity and return potential – two advantages that we think are especially important in today’s market.
The low-down on the lock-in
Bank certificates of deposit at an insured bank in the U.S. offer a fixed interest rate, typically higher than that on a standard savings account, and as bank deposits, they are insured up to $250,000 (per account, per bank, per ownership category) by the Federal Deposit Insurance Corp. (FDIC) in the event that the bank fails.
However, CDs are time deposits, requiring a specified investment period, anywhere from a month to several years. We think this can create drawbacks for investors today:
-
Limited liquidity: CD lock-in periods typically last until their maturity dates, often between six months and five years, and withdrawing early usually means incurring penalties or forfeiting interest earned.
-
Low yields: According to Bankrate, national average CD rates currently range from 0.72% for one year and 1.29% for five years, which are still near their historical lows and lower than the federal funds rate, three-month Treasury bills and Libor. (See chart.)
-
Lack of inflation protection: Rates on many CDs are below the rate of inflation, which means the purchasing power of investors’ cash is actually eroding. The headline U.S. Consumer Price Index (CPI) stands at 2.9% year-over-year through July.
-
Concentrated risk: The performance and timely payment of interest and principal on CDs are tied directly to the solvency of the bank or institution that issues them; any investment above the FDIC guarantee limit of $250,000 is exposed to bank credit risk.
Source: FDIC, PIMCO, Haver, Crane Data, Bloomberg as of 30 June 2018
The upsides of higher liquidity and return potential
Actively managed ultra-short-term and short-term strategies may offer investors an attractive alternative to CDs.
-
Increased liquidity: Because ultra-short-term and short-term strategies do not require lock-ins, investors, depending on the investment vehicle they select, may have the ability to access their funds and reinvest more quickly. In today’s market, this can mean the flexibility to reinvest as interest rates rise and when prices for other assets, including equities, become attractive – the very reason that many investors today may be holding high cash and short-term allocations.
-
Enhanced return potential in exchange for a modest increase in risk: Ultra-short and short-term strategies invest largely in short-maturity, high quality bonds with modest risk, so they have typically offered higher yields than bank CDs and aim to achieve higher total returns than traditional short-term benchmarks, such as Libor or three-month Treasury bills.
-
Potential to beat inflation: The higher return potential of short-term strategies can increase the likelihood of beating inflation over time and preserving investors’ purchasing power.
-
Greater diversification: Actively managed ultra-short-term and short-term strategies can typically invest in a broad range of fixed income, including government bonds, agency bonds, securitized assets and corporate bonds.
While actively managed ultra-short and short-term strategies come with these distinct benefits, including the pickup in return potential, investors need to carefully weigh the pros and cons. Unlike bank CDs, ultra-short-term and short-term strategies are not insured by the FDIC, are not a deposit or obligation of a bank, and are not guaranteed. They are subject to investment risks, including possible loss of principal.
Time for an update?
Since the heyday for bank CDs in the 1980s – when interest rates were in the double digits – cash management has evolved significantly. Many investors today find it beneficial to “tier” their cash and short duration assets based on their need for liquidity.
CDs may be attractive for conservative investors seeking federal deposit insurance. However, for investors looking to maximize the flexibility and yield potential on their excess cash, CDs in this current upward rate environment might not be the best instrument to replay.
Dynamic ultra-short-term and short-term bond strategies may be more adept in today’s rising rate environment: Diversified short-term bond strategies aim to find the best opportunities for high quality yield, while potentially offering increased liquidity, attractive return potential and diversification in exchange for a modest increase in risk.
Consider them akin to a wide-ranging, thoughtfully curated digital music library, where the next great song is just a click away. Do you really want more CDs?
DISCLOSURES
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
© PIMCO
© PIMCO
Read more commentaries by PIMCO
