Weekly Market Update March 31, 2023
Dow Jones Industrial 33,274 +3.2%, S&P 500 4,109 +3.5%,
Nasdaq 12,222 +3.4%, US Ten Year 3.47%, West Texas Intermediate $75.66
This week saw strength in equity markets after no new banking crises re-emerged over the last week. Every day that goes by without a new story of bank-run contagion makes it more and more likely that the events we saw at Silvergate Bank, Signature Bank and Silicon Valley Bank could be isolated events. Bank stocks are still under pressure, even the large-cap names, due to the three bank shutdowns mentioned above, banks are now having to pay higher savings account and Certificate of Deposit rates to attract and keep deposits. This causes a compression in lending margins and negatively impacts bank’s earnings. In fact, CD yields over the past couple of weeks have for some maturities now overtaken those of short-term Treasury bills (more on this below). If there is a silver-lining from the demise of these banks, it is that investors now have another safe option for investing in the short-term to earn better returns.
Before going into the details of the new investment opportunities mentioned in the prior paragraph, here’s a quick review on a few terms and definitions that investors should consider before investing in short-term fixed-income investments:
Credit Risk – The risk of loss that could come from a borrower’s inability to repay a loan. The riskier the lender, the higher the yield will need to be to attract an investor.
Interest Rate Risk – The risk of the loss of value of a fixed income investment due to a rise in market interest rates while holding the investment. The prices of bonds and interest rates are inversely related – when rates go up, bond prices fall. And if you own a bond or bonds, the value of this holding will fall if interest rates spike higher.
As we have discussed in prior letters, U.S. Treasury securities have effectively zero credit risk, because they’re fully backed by the U.S. government (or the taxes the federal government can levy on Americans). Treasury bonds DO carry interest rate risk, but this risk is removed if an investor is willing to hold the bond to maturity. In other words, if you buy a one-year Treasury bill and rates increase while you own the bill, the value of the investment will drop while you are holding it. But that becomes irrelevant if you’re committed to holding the bond to maturity. At maturity you get paid back the principal and interest on the bond, and what happened to rates during that time frame does not matter. Holding a bond to maturity effectively immunizes an investor from interest rate risk.
As a consequence of the Fed’s battle against inflation, short-term Treasury rates have now become an attractive area in which to invest. Investors are currently getting paid MORE to buy Treasuries that mature in one-year or less than you are for investing in Treasuries of longer maturities. This is the inverted yield curve you have likely heard so much about recently. Now, enter the next saga of our current economic picture: The bank failures mentioned above have forced banks to raise the yields on CDs to attract deposits. Less than a month ago, CD rates were generally not as attractive as T-Bills with a maturity of one year or less. That has now changed (see table below).
*Source: Charles Schwab. Indicative levels only as of 3/31/23
Currently the gross return of CDs in the 9-Month and 1-Year maturity are higher than those of U.S. Treasuries. However, it is important to take into account the tax-effect on the yields of Treasuries versus CDs, because with CDs you pay federal and state income taxes; with Treasuries you pay only federal income taxes. So, the tax adjusted rates (using a 5% state tax rate) are as follows:
Using a 5% state tax rate we see that as of the last day of the month, CD rates are paying a higher rate in the 3-month, and 12-month maturities. These rates fluctuate for both instruments. Earlier in the week CDs were paying higher for 9-month and 12-month maturities but not the 3-month treasury!
What does this mean for investors who have extra cash sitting around earning nothing? As we’ve discussed before, a short-term Treasury ladder is a great way to create income and reduce overall portfolio risk. We’ve also discussed how the “rungs” of the ladder give an investor the opportunity to re-invest or re-deploy cash when bonds in the ladder mature. However, now that CDs offer higher yields in some instances, we can now add CDs to the mix for customers interested in creating these short-term income generating accounts.
There are some notable differences of which to be aware of when buying a CD versus a bond. Most CDs are less liquid than treasury securities and do not readily trade in the secondary market. So, if you run into a “rainy day” situation, selling a CD may take time due to the lack of liquidity, and you may even have to sell it for less than what you paid. On the flip side, CDs are insured up to $250k from the FDIC. If you are confident that you will not need the funds before maturity, then adding to your portfolio a CD yielding higher than the equivalent maturity treasury security may make sense.
We monitor the moves of CD and bond yields every day for our clients and can help you take advantage of the moves in Treasuries and CDs to create income and portfolio stability. For maturities of less than one year, yields are at levels not seen in nearly 15 years. If you are interested in taking advantage of the Fed’s battle against inflation, along with the recent struggles in the banking sector, please contact your advisor.
“In the midst of every crisis, lies great opportunity.”
Have a great weekend,