Don't Settle for a Second-Best Investment
When it comes to buying stocks cheaply, discount brokers have revolutionized the financial industry. By taking what used to be costly transactions and making them affordable, discounters opened up the stock market to ordinary people with only modest amounts to invest.
But in their quest to bring a wide range of services to investors, even discount brokers don't always get everything right. With some types of investments, you could do better if you go directly to specialists rather than going through your broker.
Starving for income
One area in which discount brokers have been beefing up their offerings is in fixed-income securities like bonds and bank CDs. With interest rates at extremely low levels, investors have had to take extreme measures to search out higher yields for their portfolios. Yet even though dividend-paying stocks have gained in popularity, many investors don't have the risk tolerance to give up on fixed-income investments entirely.
In particular, CDs have become attractive as a place to park short-term cash. With money market mutual funds yielding next to nothing, brokered CDs offer the security of FDIC insurance and the convenience of being able to buy through your regular brokerage account.
The best rate?
What you might not realize about brokered CDs, however, is that they're slightly different from CDs you'd get directly from a bank. As a result, you can sometimes find better deals by bypassing your broker and opening an account of your own with the CD-issuing bank.
For instance, I recently looked at CD offerings available through one of my discount brokers. I found CDs from a wide variety of well-known issuers. As I expected, the rates were fairly low, reflective of the weak rate environment.
But the real surprise came when I compared those rates with the ones the issuers offered through their online banking websites. For instance, Discover Financial (NYS: DFS) offered brokered CDs with six-month maturities for 0.35% or one-year for 0.5%. But when I went to Discover's website, I found rates of 0.75% and 0.9% respectively on the exact same terms. Similarly, a division of General Electric's (NYS: GE) GE Capital offered a rate of 0.8% on a two-year brokered CD, but Metlife Bank, which the GE unit has agreed to buy, offers a similar two-year CD with a 1.17% rate.
Sometimes, issuers offered slightly different terms than you would get from them directly, but the direct offerings were still better. An example was CIT (NYS: CIT) , which offered a four-year brokered CD at a rate of 1.15% when its website featured a three-year CD at 1.42%.
Paying the middleman
Why the disparity? The key lies in how brokered CDs work. Brokered CDs by definition are sold through brokers rather than directly by a bank, and so the broker has to figure out a way to make money from its transaction. It can do so either by charging commissions to its customers or by collecting fees from issuing banks. Many brokers choose the latter, and banks respond by cutting their interest rates to recoup those fees. By contrast, banks can issue regular CDs directly without any additional regulatory hassle. Because it's much easier to do so, banks can afford to pay higher rates on those direct CDs.
Now to be fair, some institutions offer better rates on their brokered CDs than they give direct customers. Huntington Bancshares (NAS: HBAN) , for instance, had six- and 12-month CDs yielding 0.35% to 0.45%, greatly exceeding the bank's direct CD rate of 0.20%. In other cases, a given CD's rates are reasonable in light of similar products from the bank. JPMorgan Chase (NYS: JPM) had a 78-month CD with a step-up feature that yielded 1.54%, compared to 1.1% for its direct-sold five-year CD and 2% for a 10-year CD.
Know what you're buying
The lesson here isn't that discount brokers are evil and trying to trick you into accepting subpar investments. But brokers are in the business of making money, and whenever they offer you a product, you can be certain that they're not doing it just out of the goodness of their hearts.
For many, the added convenience of having a wide array of CDs from different banks will be worth a slightly lower yield. But in an environment in which investors are squeezing every penny they can from income-producing investments, you may find it worth the trouble to do a little extra legwork to avoid settling for second-best.
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At the time this article was published Fool contributor Dan Caplinger saves the best for last. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned, although he does own some brokered CDs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never second-best.