Besides laddering and barbelling, there is another fixed-income investment timeframe strategy you can use. I call this strategy anticipating because you are anticipating what interest rates will be in the future. Anticipating is the best strategy, but it is more difficult to execute; and you may want to temper it with a laddering affect to lessen the greater risk associated with it.
The most difficult part of executing an anticipating strategy is projecting what interest rates will likely be in the future. Fortunately, the United States Congressional Budget Office (CBO) projects what 3-month and 10-year U.S. Treasury rates will be about 10 years into the future. From this information, we can estimate what 5-year U.S. Treasury rates, average 5-year CD rates, well-chosen 5-year CD rates, et cetera are likely to be in the next 10 years.To see a list of high yielding CDs go here.
CBO projections differ a little from the projections by the 19 members and potential members of the U.S. Federal Reserve System (Fed) Board of Governors and the projections by the about 50 private-sector economists who contribute to the Blue Chip consensus. For instance, the 19 members and potential members of the Fed Board of Governors project the target federal funds rate being raised from 0-0.25% in 2015. The CBO does not project this happening until early 2016. The Blue Chip consensus projected 10-year Treasury rates in the fourth quarters of 2013 and 2014 at 2.2% and 2.7% respectively. The CBO projects these same rates at 2.3% and 2.9%. However, Fed, Blue Chip, and other projections by economists are similar enough to CBO projections to give credence to the CBO projections.
In the February 5, 2013 The Budget and Economic Outlook: Fiscal Years 2013 to 2023 report, the CBO projected 3-month and 10-year Treasury rates as follows.
As you can see, the CBO projects Treasury rates to increase and, then, hold steady. These projections account for “inflation, federal borrowing, and the factors that underlie the growth of potential GDP”. The CBO projects inflation to increase to and, from 2018 onward, level at 2% to 2.3%, depending upon which measure is used. Per the CBO, “the rate on 10-year Treasury notes adjusted for inflation is projected to equal about 3 percent from 2019 to 2023 (and 2017 to 2018), higher than its long-run historical average primarily because CBO forecasts a higher-than-average ratio of federal debt to GDP”. Basically, the CBO projects 3-month and 10-year Treasury rates to reach 4% and 5.2% respectively in late 2017 and, then, remain there.
It seems to make sense to manage your fixed-income investments so they mature in late 2017; but the question is, actually, more complicated. You need to invest in something from 2013 to 2017, and you will earn a certain return on this investment. Currently at least, the best fixed-income investments for a timeframe of about 5 years or less are well-chosen CDs. A 5-year CD has a higher interest rate than a 4-year CD, so maybe you are better off with a 5-year CD maturing in 2018. A 3-year CD has a lower interest rate than a 4-year CD; but, since it matures sooner (i.e., in 2016), you will, theoretically at least, experience higher future interest rates sooner. To answer the question more definitively, we need to project future well-chosen 5-year CD rates―and do some math beyond this.
To project well-chosen 5-year CD rates, I will first project 5-year Treasury rates based on the CBO’s 3-month and 10-year Treasury rate projections. Then I will project average 5-year CD rates based on the projected 5-year Treasury rates. Then I will project well-chosen 5-year CD rates based on the average 5-year CD rates.
Using every-Friday U.S. Fed data from January 8, 1982 to April 19, 2013, the average 3-month, 5-year, and 10-year Treasury rates were 4.56%, 5.92%, and 6.39% respectively. The difference between the average 5-year rate and the average 3-month rate was 74% of the difference between the average 10-year rate and the average 3-month rate. This statistical relationship makes sense. Generally, you get a higher rate for committing your money for a longer period of time; but this benefit is less the further out you go.
Using every-Friday U.S. Fed data, in 2012, the average 3-month, 5-year, and 10-year Treasury rates were 0.09%, 0.76%, and 1.80% respectively. The difference between the average 5-year rate and the average 3-month rate was 39% of the difference between the average 10-year rate and the average 3-month rate. This statistical relationship is an anomaly that will correct over time. Making a long story short, using the 74%, 39%, and other statistics, I projected 5-year Treasury rates to be as follows.
Next, using weekly U.S. Fed and St. Louis Fed data from the end of 2000 to today, I determined that average 5-year CD rates best match 5-year Treasury rates when the CD rates data is 26 days ahead of the Treasury rates data. In other words, it appears that 5-year CD rates are being determined based on 5-year Treasury rates and other factors with about a 26-day delay. The relationship between average 5-year CD rates and 5-year Treasury rates is, usually, a close one―except that average 5-year CD rates are less volatile than 5-year Treasury rates, as you can see in the chart below. In the chart below, the average 5-year CD rates are in blue and the 5-year Treasury rates are in red. The data points are plotted, as well as a line representing the 2-week moving average.
From the end of 2000 to today, with the 26-day delay, average 5-year CD rates were, on average, 96% of 5-year Treasury rates. Using this statistic and adjusting for the 26-day delay, I projected average 5-year CD rates to be as follows.
Well-chosen CD rates are higher than average CD rates. I was unable to find strong historical data on well-chosen CD rates, but I was able to find some data. Based on this data, I decided to project well-chosen 5-year CD rates to be a fixed percentage above average 5-year CD rates. I did this despite the fact that there were indications that the spread between well-chosen 5-year CD rates and average 5-year CD rates increases as interest rates increase. Basically, my well-chosen 5-year CD rate projections may be somewhat low for the points in time where the other rates are projected to have largely increased.
To determine the fixed percentage, I used Melrose Credit Union data from November 11, 2009 to today as reported by DepositAccounts.com. I used Melrose data because (1) its CDs are NCUA (National Credit Union Administration) insured, (2) its CDs are available to everyone in the U.S., (3) there are no more-cumbersome requirements for opening an account or buying a CD, (4) in recent years, at least, it has offered good, and sometimes the best, CD rates, and (5) I did a check on Melrose last year and it appeared to be sound. Melrose’s 5-year CD rates were about 1.24% higher than average 5-year CD rates during the time period studied. Using this statistic, I projected well-chosen 5-year CD rates to be as follows.
The next step was to project well-chosen 5-year CD rates on May 3 of each year. The upcoming Friday is May 3, but the projections we have so far are calendar-year-average projections.
Now that we have well-chosen 5-year CD rate projections for each May 3, we can more definitively evaluate whether the best CD is a 3-year, 4-year, or 5-year CD. We will use current Melrose CD rates to do this.
As you can see, it is a close call between buying a 4-year or a 5-year CD; however the 4-year CD appears to be the better choice. To be more specific, I am not recommending you buy a 4-year CD and, then, buy a 5-year CD with your fixed-income investment money. Only CD rates were used in the analysis above merely to keep things simple and have an apples-to-apples comparison.
I am recommending you consider buying a 4-year CD―or a 4-year CD and a 5-year CD―and, then, buying whatever investment is best for you at the time. This investment may be longer-term corporate bonds or municipal bonds. Currently, it seems you need a 10-year corporate bond rate of greater than about 3.96%, less expenses and average default losses given the quality of the bond, to beat buying a 4-year CD. For municipal bonds, this 3.96% rate is lower by the amount of associated tax savings you will experience. Corporate and municipal bonds like these are, at least, challenging to find. Four or five years from now, longer-term corporate and municipal bonds will likely be much more competitive.
The CBO’s projections or, more so, my projections may be significantly inaccurate. As I mentioned earlier, the spread between well-chosen 5-year CD rates and average 5-year CD rates may increase as interest rates increase. On the other hand, CD rates may end up lower because the “higher-than-average ratio of federal debt to GDP” the CBO is forecasting alters the relationship between CD rates and Treasury Rates. Also, we may end up in a period like 2006 and earlier 2007, wherein average 5-year CD rates trailed 5-year Treasury rates by a substantial amount.
This being the case, I did a sensitivity analysis. I left the shape of the projected increase in well-chosen 5-year CD rates intact, but I lessened or increased the well-chosen 5-year CD rate that will eventually be reached. The results were as follows.
As you can almost fully see, the 4-year CD projected the best in all but the -2% category. The 5-year CD projected the best in the -2% category and second best in all other categories.
Manage your fixed-income investments so they mature in about October 2017―or so they mature more during this time period. October 2017 is the month the above data indicates as the best. There is no guarantee you will do better by doing this, but the odds will be in your favor.To see a list of high yielding CDs go here. Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.