Yes, You Can Find 'Alpha' In Fixed Income - In Safe, 100% Insured CDs

by: Psycho Analyst

Summary

Common misconceptions about CDs encourage many retirees to take on more risk than necessary as they search for income.

CDs can be found paying 2% to 3% risk free.

Many people don't realize it is possible to extend FDIC or NCUA insurance to CDs in amounts many times over $250,000.

In discussions that have arisen in the comments section of articles frequented by retirees, I have several times posted about the high rate CDs I invest in. These comments have always resulted in questions that make it clear that many retirees are unaware that they can satisfy their need for income using a safer alternative to investing all their money in dividend stocks whose share prices are at the mercy of a highly irrational and volatile market.

Unlike investing in bonds, which are the traditional alternative to investing in stocks, investing in CDs also limits interest rate risk - the impact of unexpected rises in inflation or interest rates. That's because CDs keep your principal intact while giving you the ability to withdraw your money from the CD if more attractive rates become available, in return for paying a small early withdrawal penalty, which is defined at the time you buy the CD.

While the money invested in a bond fund paying 3% today might have a loss of 6% of its value should rates unexpectedly rise 1% (given a 6-yr duration), all you can lose with a CD is some of the interest you were paid during the previous year - three months to a year's worth depending on the specific terms of the CD. So if rates ever do rise to 4%, you could quickly take advantage of those more generous rates, while stock holders and bond holders will be stuck with whatever interest the stock or bond was paying before the drop - and a possible large decline in share price due to new investors preferring the higher yield available elsewhere.

But because the CDs you buy directly from credit unions and banks don't form part of the assets under management that enrich investment advisors, you never see them discussed as a legitimate investment for those saving for retirement or funding their retirements. Investors who remove assets from the world of stocks and bonds don't earn a penny for Wall Street, so these wonderful investments pretty much fly under the radar.

What kinds of above-average rates are available in CDs?

If you wonder how high their yield is, here are some examples. Over the past three years, I have found two CDs offered that paid 3.05%, one for a 3-year term and the other for 5 years. Both had reasonable early withdrawal penalties, so if rates were to surge during the term of the CD, I could withdraw my money and only pay back in one case one year's worth of interest, in the other, 6 months worth of interest. This is far less than I would lose had I invested the same amount of money in a bond or bond fund paying that amount should rates surge.

These good rates pop up from time to time each year. You have to do some hunting to find these high yielding CDs as they are never advertised, but they can be found online and it is definitely worth spending the time to find them.

The most recent CD purchase I made at 3.05% was a 3-year CD purchased this past September, though unfortunately it was limited to $100K. An earlier 5-year 3.05% CD offered in 2014 had no limit, and you better believe I loaded up the truck with whatever I could find to invest while it was available. In the last few years I also have bought a 4-year CD paying 2.32%, two 5-year CDs paying 2.50% and 2.52%, and several 5-year CDs paying 2.25%. In all cases, these 5-year CDs could be broken and all my money withdrawn after paying a 6 months interest penalty. However, given the sorry state of rates over the past few years, I have not yet found any reason to break any of my CDs.

Since these rates are competitive with those paid by many dividend stocks, and are better than what I can find in all but the riskiest bond funds, I am very happy with them. I invest in a ladder of varying maturities, so every year a certain amount of money comes due, which I reinvest in the longest CDs I can find that pay well. In times like this, when market volatility can be a concern, these fully insured interest paying deposits let me sleep very well at night.

How can you find these great rates?

The best way to find the best rates is to check the daily blog posted at the DepositAccounts web site found here. That site also provides a searchable list of current rates for all different kinds of accounts and for CDs of various terms and a map showing what rates are available in your geographic area.

I have also found several very good rates available locally by phoning around to local institutions that I have dealt with in the past. Some local institutions will offer you a rate better than what they list publicly if you are willing to buy a Jumbo CD - one over $100,000.

I've been buying CDs since the 1980s, and have learned over the years that the best CD rates are often found at credit unions. The good news is that, unlike the situation many years ago, you are no longer limited to using only the credit unions found in your area or to the credit unions that serve those who work for your employer.

This is because there are many credit unions that have very easy terms for membership. For example, you can join the Pentagon Federal Credit Union (PenFed) by making a very small donation to the National Military Family Association. I like knowing that the CDs I hold there make it possible for PenFed to help members of the armed services get very inexpensive mortgages and car loans.

Other credit unions are open to anyone who joins the free American Consumer Council. Yet other credit unions let you join by contributing a token amount to a local library or museum.

Best of all, many of the credit unions with the best rates are active online and can be joined by anyone who has access to a computer. Some of the nationally available credit unions I currently have deposits with include the NASA Federal Credit Union, PenFed, and Northwest Federal Credit Union. The latter credit union is part of a large network of credit unions, which allow deposits at each other's physical branches. This means I can do walk-up transactions with Northwest Federal Credit Union at the offices of a local credit union, even though I am not a member of that local credit union.

Credit Union CDs can have some special features that make them ideal for retirees. Many allow you to take out the interest paid every month by your CD rather than have it compound, thus providing that income flow so essential to the retiree.

Another wonderful feature for everyone saving for retirement is that some credit unions offer "Add-on" CDS. After you open one of these, you can add new money to the CD at any time during its term. One such CD, which I opened with a local credit union, allows me to also withdraw partial amounts from the CD during its term, while paying the usual Early Withdrawal Penalty only on the amount I have withdrawn. This means I can put a large amount of money into that CD without worrying that I might need that money for some emergency.

If you are invested in an IRA CD, you will be able to take money out to pay your required distributions without any penalty. You may also be able to access the money in CDs if you become seriously ill. Discuss the availability and details of such features with the institution that offers the CD. The terms can vary from place to place, so make sure you know exactly what the specifics are, though there are laws about IRA CDs that apply to all.

Credit Union CDs are insured by NCUA, a Federal organization that offers insurance identical to that offered by the FDIC.

The other institutions most likely to offer the best CD rates are smaller locally owned community banks. Some of these have a limited area where they offer services. However, I discovered that one such bank that is almost 2 hours from my home would allow me to join online and take advantage of a very good rate because my zip code was in their database.

Some banks that started out as community banks have developed a large internet presence and provide good online interfaces, which allow you to open your CD and make your deposit into the CD with a simple, free ACH transfer from your local bank. Sometimes it can take a few steps to complete your deposit, as the institution will want to verify that you really own the account you want to transfer from. However, I find it takes considerably less of my time to open a CD online than it does to walk into a local bank, where I get to waste a lot of time while the bank officer fills out reams of paperwork and wanders back and forth to pick up forms from the printer.

When a CD comes due, you will be given notice a month or so beforehand, and can instruct the institution as to how you want the money handled. Some institutions will let you move the proceeds into a checking account and then ACH transfer the money to another bank. Others will mail you a cashier's check. So far, I have not run into any problems getting my money out of CDs that have come to maturity. With a local credit union, I have even been able to get my money out of a CD that rolled over to a lower rate CD before I remembered to withdraw it, without any penalty, even though the period during which such withdrawals are officially permitted had passed.

How you can get around the $250,000 limit on Deposit Insurance

If you are fortunate enough to have a large amount of money to invest in fixed income, you may have thought that it would be too much bother to buy CDs from credit unions or banks because of the $250,000 per account limit on how much can be insured.

However, many - though not all - institutions will allow you to create a POD (Payable on Death) trust account. This is an account that you control 100% while you live, but if you die, the account transfers, outside of probate, to your chosen heirs who are listed on the CD as beneficiaries. You can also make a charity a POD beneficiary. Adding additional people or charities to your POD account increases the amount you can insure, as they are treated as joint accounts.

There are calculators online that will tell you exactly how much you can protect by adding beneficiaries to your account.

This will tell you how much you can cover in an FDIC insured bank account.

This will tell you how much you can cover in an NCUA insured credit union account.

However, because POD account assets pass outside of probate and ignore the terms of your will, if you are going to put significant amounts of money into this kind of account, you should make sure that you talk to the attorney who drew up your will to ensure that you don't do something that conflicts with how they have set up your estate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.