How does a 5-year PenFed CD fit into TIPS strategy?

This blog is focused on Treasury Inflation-Protected Securities and I Bonds, both inflation-protected investments. So you might wonder why I’ve been ‘all excited’ about a 3% 5-year CD being offered by the Pentagon Federal Credit Union through Jan. 31, 2014.

One word answer: Math.

The bigger picture is that my wife and I try to keep an asset allocation of 40% stocks and 60% bonds, with a heavy allocation of bonds in tax-deferred accounts. But that is just the ‘asset type’ allocation. In addition, I monitor our ‘inflation-protected allocation‘, which I’d like to be about 15% to 20%.

I also try to monitor our ‘asset safety allocation‘, which I have written about before, and it looks something like this:

  • 10% Highest risk: International stock funds, smaller-cap stock funds
  • 30% Higher risk: Total stock market funds, S&P 500 funds, etc.
  • 35% Lower risk: Broadly diversified bond funds, TIPS funds, municipal bonds
  • 25% No risk: TIPS, I Bonds, insured bank CDs, Treasurys held to maturity

Those numbers might vary, and in fact it has been hard to keep the no-risk category up to the desired level with yields so low. I Bonds are especially helpful, because they are tax-deferred but not in a tax-deferred account. The only problem with I Bonds is the yearly purchase cap ($10,000 per person per year, plus $5,000 possible as a tax refund.).

Everywhere you turn today you see articles warning about the dangers of bond investments. And my answer to that is: Find safety. By buying TIPS, I Bonds and insured CDs – and holding to maturity (whatever you choose for I Bonds) – you completely eliminate risk. Your principal balance is not going down.

So along comes the PenFed CD, federally insured for 5 years paying 3%. It fits into the ‘no risk’ category,  it’s in the fixed-income category, it can be purchased in a tax-deferred account, and the insured limit is a lofty $250,000. But it does not offer inflation protection.

So how does it compare with a 5-year TIPS, an I Bond or a traditional Treasury? Here’s the math, with the winning investment highlighted for each inflation rate:

5 year CD analysis

Conclusion: This 5-year CD, especially in a tax-deferred account, can be a nice supplement to your I Bond investment this year. And since the I Bond fixed rate of 0.2% is intact through April 30, there is no rush to buy I Bonds. The PenFed offer lasts through Jan. 31, though, so time is limited on that investment.


About Tipswatch

Author of blog, David Enna is a long-time journalist based in Charlotte, N.C. A past winner of two Society of American Business Editors and Writers awards, he has written on real estate and home finance, and was a founding editor of The Charlotte Observer's website.
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11 Responses to How does a 5-year PenFed CD fit into TIPS strategy?

  1. Pingback: ‘Real’ return: Why TIPS and I Bonds are still attractive | Treasury Inflation-Protected Securities

  2. Pingback: PenFed drops its 5-year CD down to 2% | Treasury Inflation-Protected Securities

  3. Thomas says:

    I am so glad you found this PenFed deal. I had been studying bonds and what is available at Fidelity brokerage. I would have had to go down in quality to A-rated corporate bonds and risk an early call or bankruptcies to get that 3% yield.

    I am scraping out my bank accounts and selling some mutual fund holdings to buy as many of these as I can. I am tempted to buy the seven year CDs at 3% since they would mature at a sweet time in my retirement.

  4. Pingback: Buy I Bonds now, or wait until later in 2014? | Treasury Inflation-Protected Securities

  5. tipswatch says:

    Jim, no the -0.3% return for the 5-year TIPS is after inflation. So it will never outperform inflation. If Inflation averages 2.0%, it will return 1.7% before inflation and -0.3% after inflation, and the 5-year CD will return 3% before inflation, and 1% after inflation, for an advantage of 130 basis points over the 5-year TIPS.

  6. Jim Carlson says:

    What i don’t understand about this analysis/conclusion: When i look at the table (for example), under the column for 2.0% inflation, doesn’t the 5-yr TIPS outperform the CD under that scenario? (i.e., -0.3% + inflation = more than 1% return for the CD).

  7. tipswatch says:

    Ron, I do assume I will collect Social Security but I don’t calculate that into my asset allocation or safety allocation. That makes my conservative investing style even more conservative.

  8. Ron M. says:

    When you do your inflation-protected allocation and/or your asset safety allocation do you include your expected Social Security benefits (assuming you are old enough that you feel they are not likely to be messed with by Congress) as part of the percentage?

  9. tipswatch says:

    Joe, I agree with your analysis. But when I buy a 5-year TIPS, I am not going to lose any principal either, because I am keeping it to maturity. Even then the PenFed CD will be the easy winner unless inflation dramatically escalates. And if that happens, my other TIPS and I Bond holdings will kick in to cover me. This PenFed CD, with its obviously above-market rate, can help mute risk in your fixed-income allocation, which might face a rocky 2014.

  10. joe says:

    So lets compare a 5 year tip to a penfed 3.04% 5 year cd. The tip gives you a real yield of -.269, so you would need an inflation rate of 3.31% to beat the cd plus you take on interest rate risk. Also, with the penfed cd, selling early you can’t get less than your principal. I think the penfed cd is clearly the winner. I actually had a bunch of old cd’s just mature, so I just rolled them over to the 3.04% cd as I felt it is a better deal than the 5 year tips on the secondary market. If real yields improve tomorrow, I can easily sell the penfed cd’s without loss of principal. The only thing is to keep below the fdic limits just in case of penfed going out of business.

  11. Ed says:

    Stock price and home price histories have clearly been dominated by the coming & going of irrationality. See here:
    These very instructive histories are effectively kept out of sight, deceiving the people. Is your ‘allocation/diversification thinking’ much dependent on continuation of this ‘out of sight’ status quo?

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