Steep Yield Curve Makes Certificates of Deposit an Excellent Alternative for Short-Term Treasuries

Sometimes, the best way to define an investment is not by its name, but by its function. For example, a stock might provide growth of principal, but so might a commodity investment. A bond might provide income, but so might real estate. Focusing on function rather than on narrow categories of investments helps you consider a broader range of alternatives, which can lead to better choices. An example right now would be viewing short-term certificates of deposit as an alternative to short-term Treasuries.

U.S. Treasuries bills, notes, and bonds provide safety and income, but lately that income component hasn't been worth very much. It is in this income component that certificates of deposit distinguish themselves as an alternative.

Treasury Yields

Long-term Treasuries almost always yield more than short-term Treasuries, but lately the upward slope has been particularly steep from short-term yields to long-term yields. As of early July, 3-month Treasuries yielded an annualized rate of 0.18%, while 30-year Treasuries yielded over 4% higher, at 4.37%.

There are a few reasons why there is such a contrast between short and long yields. The Federal Reserve is making a concerted effort to keep interest rates low as an economic stimulus, and Fed policies typically affect short rates more directly than long ones. Also, there is a contrast in marketplace concerns -- short term, investors are focused on the continuing recession, while long term they are worried about a resurgence of inflation.

CD Rate Alternatives

In viewing certificates of deposit as possible alternatives for short-term Treasury investments, a good starting point is to acknowledge that CD rates will generally be higher than Treasury rates. After all, Treasuries have superior safety and liquidity characteristics, so CD rates have to offer more in the way of yield. What's striking, though, is that with short-term Treasury rates especially low right now, short-term CD rates have an especially strong advantage.

In particular, some of the best CD rates in the 6-month to 2-year range have an advantage of 1.6% or more over their Treasury counterparts. Move out to the 5-year range, and this advantage drops to more like 1.2%.

Why is this striking? Because the advantages of safety and liquidity that Treasuries offer should be less of an issue on the short end of the yield curve, not more. In this case, it seems to be that short-term Treasury yields are unnaturally low, and this makes short-term CDs a very viable alternative.

Weighing Risks and Limitations

There is no such thing as a free lunch, so when you see an investment offering some extra yield, you have to ask why. In the case of CD rates, the extra yield comes with risks and limitations that would seem perfectly acceptable to most investors.

For example, Treasuries are backed by the full faith and credit of the U.S. Government--but with FDIC insurance, CDs effectively have the same thing, at least for investments of $250,000 or less. Treasuries are also more liquid--they are traded every day, whereas CDs can only be cashed in early by paying a penalty. However, for many investors, short-term CDs have enough built-in liquidity to meet their needs. In other words, before buying a short-term Treasury, it's worth looking at short-term CDs first.

 

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