I received this interesting question from another financial advisor recently:
Six months ago I purchased a three-year CD paying 4%. Now that same CD is showing a internal rate of return loss of -1.39%. How is this correct? How can a CD, guaranteed to pay 4% and guaranteed not lose money have lost money?
Great question. Many people don’t understand how fixed income is priced, so let me take you through the math.
Let’s assume that the face value on your certificate of deposit (CD) is $100,000.
It doesn’t matter how long ago you purchased your CD paying 4%; it only matters how long is left on the CD. Currently, you hold a 2.5 year CD paying 4%. That 4% number is the annual compounding return, but the CD pays monthly. In this example, it is a monthly payment of 0.32737% per month or $327.37. That is the rate of monthly return which will compound to be 4% in a year. The math for the monthly payment is (1+0.04)^(1/12)-1 = 0.32737% where 0.04 is the advertised annualized return.
In addition to the monthly payment, in 2.5 years, you will also get your $100,000 back.
The problem is that the current going rate for a 2.5 year CD is now 5.50%. Why would anyone pay $100,000 for a 2.5 year CD which only pays 4% when you can purchase a new CD paying 5.5%? A 5.5% annualized rate would pay you $447.17 every month rather than just $327.37 per month.
For this reason, your $100,000 CD paying 4% is not worth $100,000 in the open market. And in fact, it is only worth $96,643.76. This discounted amount is the price at which your $327.37 monthly payment results in an internal rate of return (IRR) of the new going rate of 5.5%.
They have given you six months of interest for a total of $1,964.22, but you have also lost -$3,356.24 because your CD has dropped in value. This is currently stated as a -$1,392.02 total loss (-1.39%), but you will average 5.5% for the next 2.5 years in order to get back to a 4% annualized return. Depending on your software, in the short term this could show up as a -1.39% loss, or it could annualize the loss and make it -2.78%.
Holding the CD to maturity will result in precisely the advertised return. They will have paid you 4% annualized and given you back your principal after the designated duration.
However, with your CD worth less now on the open market, if you sold now, your return would be worse. This is the interest rate risk of fixed income investments. When you purchase a CD which doesn’t mature for 3 years, you have agreed to lock your money up for three years. This results in a risk where when interest rates rise, the value of your CD goes down until it pays the same as the going rate for new CDs.
The opposite risk also occurs and is called reinvestment risk. If your current fixed income is paying a significantly better rate than the market, then, while your investment may show a gain before it matures, when that position closes your new cash would have to be invested at worse rates.
This is why fixed income has more volatility than appears at first glance. However, by holding investments to maturity you can have a known return, even if it is not necessarily the best return.
If you are looking for an investment where the valuation doesn’t vary but instead the interest rate changes, then the investment you are looking for is a money market fund. Money market funds function like a bond with zero duration.
Photo by Artem Kniaz on Unsplash. Image has been cropped.