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A Second Look at CDs

by Craig Moser on September 7, 2018

If you have some cash to invest, you may be trying to figure out where to put it. In recent years, choices have primarily been low-risk investments with near 0% interest rates, or higher risk investments hoping for a higher yield.  However, rates on investments like CDs, money markets, and short duration bonds have increased in the last several years.  So, if you’ve been looking for investment options, you may want to take a second look at CDs.

Overview

Banks issue Certificates of Deposit (CDs) and they mature between one month and twenty years.  When buying CDs, you agree to leave your money in the bank for a specific length of time in exchange for an agreed upon interest rate.

Insurance and Yield

One advantage of CDs is that they provide both interest payments and FDIC insurance.  FDIC insurance protects your money in case the bank fails.  Buying a CD from an individual bank insures your deposit up to $250,000 per person, per bank, per account ownership category.  This means if you have a joint checking account, an IRA, and a savings account at ACME Bank, your deposits are insured for a total of $750,000.

Another option is to purchase brokered CDs.  In this scenario, the CD’s are still issued by a bank, but they’re bought and sold through a brokerage firm.  The benefit of this type is CD lies in the fact that CDs can be purchased from many different banks throughout the world.  All of those CDs are then held in one brokerage account.  The advantage is you may have the potential to get more cash covered by FDIC insurance than if you owned one CD account at an individual bank.

Yield vs. Time

Another benefit of brokered CDs is they can provide different maturity dates. Like a bond ladder, this lets you gauge your yield amount against the maturity dates.  Generally speaking, the longer you leave your investments in the bank, the higher your yields.

However, the shape of the “yield curve” does change over time.  When investing you should focus on the point in the curve that best suits your needs. The yield curve (below), represents the relationship between yield and maturity. You should use the point on the curve to help guide the risk and return profile you hope to achieve in your overall CD positioning.

Shorter and longer term CDs generally have better yields than Treasuries.

Using the chart above, assume you invest $100,000 in a 3-month CD.  If the yield is 1.9%, you earn $475 during that 3 months.  Furthermore, if the yield remains constant and you reinvest the $100,000 principal amount 3 more times, you would earn $1,900 in interest.

Conversely, if you know you’re investing the money for a full year, it would be better to purchase a 1-year CD with a return of 2.4%.  In this scenario, your $100,000 would earn $2,400 in interest.

Liquidity

While CDs offer several advantages, their primary limitation is the ability to access your money. With traditional banks, withdrawing your money before maturity results in a penalty which can reduce both your yield and principal.  With brokered CDs, there is no penalty to liquidate before maturity because you may be able to sell the CF to another investor.  However, you have to accept the current market price and may incur transaction fees.

The Ladder

Generally speaking, the longer you invest, the better your yield rate.  The trade off is it that you have to wait longer to receive your principal back.  A laddering strategy can help balance liquidity and yield. It can allow you to take advantage of higher yields with longer-term CDs while also investing in CDs with shorter terms that mature earlier.

As you know, a ladder has several different rungs.  In a typical CD ladder, each rung is a CD with a different maturity.  Say your ladder contains CDs with 3, 6, 9, and 12-month maturities.  After 3 months, your first CD matures and all the other CDs move down one rung on the maturity ladder.  (i.e. your 6-month CD has 3 months remaining, your 9-month CD has 6 months remaining, etc.).  By taking the principal returned from the CD that matured first, you can continue building your ladder by reinvesting that principal in a 1-year CD.  Original rungs mature in less than a year, replaced by CD’s that pay the full 1-year rate.  In this scenario, a portion of your investment continues to mature every 3 months.

Rolling up the yield curve with a CD ladder

Thanks to regularly maturing CDs and reinvestment of them, your portfolio reflects changes in interest rates.  If rates fall, you begin to feel the impact.  However, you can take advantage of increasing interest rates when the next CD on your ladder reaches maturity.

A Second Look at CDs

The right strategy for your cash will be unique and specific to you.  When it comes to investing, there isn’t a magic bullet and one size doesn’t fit all.  However, using CDs and a strategy such as laddering may help achieve some of your financial goals.  So, if you’re looking for a place to invest your cash, you may want to consider taking a second look at CDs.

 

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