Welcome to the April edition of FAQ’s and RAQ’s!
Here we answer client questions -- some asked Frequently, and others asked Rarely.
FAQ: What is an easy way to understand the banking crisis and whether it will spread?
The torrent of headlines about the banking crisis can create confusion and uncertainty. But there’s a simple way to understand what’s happening. If you’re familiar with the mechanics of individual bonds, you can easily understand the challenge facing banks.
Banks own substantial amounts of bonds in their investment portfolios. While bond prices go up and down every day, typically that doesn’t matter for banks because they often hold bonds until they reach maturity. When bond prices fall -- as they did in 2022 when interest rates rose -- banks suffer only a “paper loss.”
Problems arise when banks are forced to sell bonds at a loss, in which case the paper loss becomes an actual loss for the bank. This is precisely the risk today. As anxious depositors withdraw money from banks, banks may be forced to sell bonds at a loss to raise cash.
This is a very different situation from the 2008 Global Financial Crisis. Back then, banks purchased bonds tied to the housing market that turned out to be worthless. In contrast, banks today generally own high-quality bonds like U.S. Treasury securities that are down in price, but only temporarily.
See the difference?
In 2008, the crisis centered on solvency, while today’s crisis is tied to confidence. If confidence improves and bank deposits stabilize – perhaps due to government assurances that it will backstop the banking system – then today’s banking crisis should subside.
FAQ: What are our favorite ideas for generating investment income?
Last year’s losses in the bond market created a range of opportunities for income-oriented investors. Below are some of our favorite ideas, each with distinct features and risks that should be considered before making a purchase.
- Certificates of Deposit – As banks strive to attract deposits, they are offering historically attractive rates on CD’s.
- Long-Term Municipal Bonds – While Treasury bond yields have declined this year after spiking in 2022, some long-term municipal bond yields have remained elevated. Combining long-term municipal bonds with short-term CD’s can enable investors to benefit from current short-term CD rates while securing tax-free income for an extended period.
- Mortgage Backed Securities (MBS) – After mortgage rates skyrocketed over the past year, bonds backed by mortgage payments offer greater return potential. There are many types of MBS. Agency MBS can be owned as individual bonds, while riskier MBS are better suited for ownership through mutual funds.
- High Yield Corporate Bond Funds – Although these bonds carry greater risk than investment-grade bonds, today's yields offer a promising starting point for generating solid returns. High-yield bonds should be held within a mutual fund to achieve broad diversification across numerous bonds.
RAQ: What is the difference between Bank CD’s and Brokered CD’s, and which is best for me?
After more than a decade of low interest rates, and -- until recently -- scant investor interest in CD’s, this is a rare question indeed!
There are two main types of CD’s: Bank CD’s, which are purchased directly from a bank, and Brokered CD’s, which are purchased through a financial advisor. Both types can make sense. The table below highlights the key differences between the two. Ultimately, the decision on which type of CD to invest in will depend on your unique situation and goals, as well as the available rates.
Please call or email if you'd like to discuss further!
Comparison of CD Types
Disclosures:
Fixed income is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risks such as interest rate risk, credit risk, inflation risk and liquidity risk. In a rising interest rate environment, the value of fixed income securities generally declines and conversely, in a falling interest rate environment, the value of fixed income securities generally increases. High-yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates.
Investors should consider the investment objectives, risks, charges and expenses of each fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus, contact your financial advisor. Please read the prospectus or summary prospectus carefully before investing.
Residential mortgage-backed securities and collateralized mortgage obligations involve prepayments. Such prepayments tend to return principal to investors when options for reinvesting may be relatively unattractive. Additional risks include significant market and liquidity risks.
Availability, pricing, and rates are subject to change.
CD rates quoted here are for brokered CDs and differ from CDs issued by banks directly to a customer. Those differences are discussed below and they should be studied carefully before investing.
Certificates of Deposit (CDs) that typically are issued by a bank directly to a customer carry a fixed interest rate over a fixed duration of time and are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 against insolvency by the depository institution. As such, they are generally considered by the investing public to be simple, conservative products that carry few risks. Brokered CDs are issued by banks via a "master CD" to deposit brokers (broker/dealer), which in turn sell interests in the master certificate to individual retail investors.
Unlike bank issued CDs, brokered CDs can trade on a secondary market, may have a longer holding period until maturity, be more complex and carry more risk than “traditional” CDs. The secondary market for brokered CDs may be limited and Baird may not make a market in the CD. If a Brokered CD is sold prior to the maturity date, that sales price may be less than its original purchase price, and particularly true if interest rates have risen since the time of the original sale.
Brokered CDs may include a provision that allows the issuing bank or other depository institution to "call" or redeem the CD prior to maturity at a given price. Call features typically are exercised when a brokered CD is trading at a premium to its call price in the secondary market. Thus, investors seeking to reinvest their redeemed funds will be subject to reinvestment risk because interest rates may have fallen since the time they first purchased the brokered CD. The call option is solely at the discretion of the issuer.
Brokered CDs may also have "step-up" or "step-down" features. A "step-down" CD will pay an above-market interest rate for a defined period of time but will then "step-down" to a lower, predetermined rate that will be paid until maturity. Similarly, a "step-up" CD will generally pay a below market interest rate for a defined period of time and will "step-up" to a higher, predetermined rate that will be paid until maturity. Customers should verify that a "step rate" on a brokered CD they are considering may be below or above then-prevailing market rates and that the CDs are also subject to secondary market risk and often will include a call provision by the issuing depository institution that would likewise subject them to reinvestment risk.