- CDs may offer higher yields than other low risk investments.
- Brokered CDs may provide FDIC insurance on a larger balance than would otherwise be possible from a single bank.
- CDs offer opportunities to lock in yields.
- A ladder of CDs may offer both higher yield and greater access to your money than a single CD held for the same period of time.
Many investors seek stable, low-risk investments but they face a challenge in trying to earn income on those investments as interest rates have moved lower. Certificates of deposit (CDs) allow you to lock in rates today that are still relatively high despite interest rate cuts.
“With the Federal Reserve cutting the federal funds rate down to a range of 0–0.25%, the yields on bank deposits and money market funds will soon begin to adjust towards these levels,” says Richard Carter, vice president of fixed income products and services at Fidelity. “Many people may be leaving money on the table by not using a portion of their cash that they do not need immediately to lock in the relatively higher rates that CDs currently offer.”
Carter says market conditions and the prospect of lower interest rates make CDs worth a careful look now.
What CDs are
CDs are time deposit accounts issued by banks in maturities from 1 month to 20 years. When you buy a CD, you agree to leave your money in the account for a specified period of time. In return, the bank pays you interest at a rate that is fixed at the beginning of that time period.
Insurance and yield
CDs offer FDIC insurance, which protects deposits in case of a bank failure. The FDIC insures bank deposits up to $250,000 per depositor, per bank, per type of account. If you had a joint checking account, an IRA, and a savings account at a bank, your deposits could be insured for up to $750,000. But not everyone wants to spread their money across multiple accounts to get FDIC insurance.
Brokered CDs, which are issued by banks but bought and sold through brokerage firms, are an alternative. The benefit of brokered CDs is that you can purchase CDs from many different banks and own them in a single account. That means more of your cash may be insured by the FDIC insurance than would be possible otherwise.
Gauging yield against time
Brokered CDs also let you buy multiple CDs with multiple maturities, which enables you to gauge the amount of yield against the length of time you wish to invest your money.
Generally, longer time commitments are rewarded with higher yields. The shape of the CD "yield curve" changes over time, however. So when you invest, you need to focus on a preferred point on the curve that best suits your needs. This does not mean, however, that you have to buy CDs only on that particular point on the curve: Rather, you should use this point on the curve as a general guideline for the risk and return profile you are aiming for in your overall CD positioning.
Past performance is no guarantee of future results.
What does that yield translate to, in terms of return? Let's say you invested $100,000 in a 3-month CD with a yield of 1%. Over those 3 months, you would earn $250 in interest, and if you reinvested the $100,000 principal 3 more times at the same rates as the CD matured, you would earn a cumulative $1,000 in interest at the end of the year.
While you benefit from liquidity as your CD matures over 3 months, you run the risk of rates changing; thus, if you plan to reinvest the principal every 3 months, your cumulative income could be lower.
If, on the other hand, you knew from the beginning you were going to allow the money to be committed for a full year, you could purchase the 1-year CD immediately at 1.10%, which would return $1,100 in interest over the year.
Access to your cash
The main limitation of CDs is that they restrict your access to your money. If you need to get your money back before your CD matures, bank CDs often charge a penalty that will reduce your yield and often your principal. Brokered CDs don't charge penalties to liquidate your position. Instead, you may be able to sell the CD to another investor. However, you would have to accept the market price for your CD and pay transaction costs. If interest rates have increased since your CD was issued, you could lose money on the sale and have a lower return than you expected, or you might not find a buyer at all.
And keep in mind that differences may exist between the price a buyer wants to pay for a CD and the price a seller is willing to sell it for.
The ladder strategy
Building a CD ladder can allow you to take advantage of the higher yields typically available on longer-term CDs while maintaining partial liquidity by also investing in CDs that will mature sooner.
A typical CD ladder consists of several CDs with different maturities. Say you build a ladder with CDs that mature in 6 months, 12 months, 18 months, and 2 years. After 6 months, the first CD has reached maturity, the 12-month CD has 6 months remaining until maturity, and the 18-month CD has 12 months. You can then take the principal from the first maturing CD and add to your ladder by reinvesting it in a new 2-year CD.
In less than two years, all the CDs with maturities of less than 2 years will have matured and been replaced by CDs that pay the full 2-year rate. (See the chart above.) Also, a portion of your investment will continue to mature every 6 months.
The regular maturation and reinvestment of the CDs mean your portfolio will reflect changes in interest rates. If rates fell, you would begin to feel the impact over time. If rates increased, you could begin to take advantage once the next CD matures. Spreading your CD investments across a variety of maturities may be a way to hedge against interest rate risk.
3 questions to ask before investing in a CD ladder
- How much cash do you need, and when?
Carter suggests thinking of a CD allocation as a middle ground between your longer-term investments and the highly liquid cash investments that you may need for daily expenses or emergencies.
Read Viewpoints on Fidelity.com: How to save for an emergency
- What are your cash flow needs?
Answering this question will help determine how frequently you would like to see your CDs revert to cash. When a CD matures, it will give you with an opportunity to reevaluate your cash needs and investment opportunities before reinvesting in a new CD.
- How much liquidity risk can you take?
Longer-maturity CDs generally offer more yield and less liquidity. You may need to pay a penalty to access your money before maturity, and there is a bid-ask spread when trading CDs in the secondary market, so you might not get the price you want if you try to sell your CDs in the secondary market. You need to determine how much liquidity risk you can take to select the maturity of the final rung of your CD ladder.
The bottom line
The right cash management strategy for you will depend on several factors, from your current financial situation to your short- and long-term financial goals. Taking full advantage of your investment options—including CDs and ladders—may enhance your returns over time.
Although CDs offer FDIC insurance, there is still credit risk.