Editors' Note

This article is published by Fidelity Interactive Content Services. The editors have selected this content because it offers valuable information for investors.

Is it time to look at CDs?

If you've been ignoring your cash, you might be missing out on higher yields.

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Key takeaways

  • CDs may offer higher yields than savings accounts.
  • Brokered CDs may provide FDIC insurance on a higher balance than is possible from a single bank.
  • A CD ladder may balance the need for yield and access to your money.

Investors sitting on cash have faced a dilemma in recent years. They could choose stable, low-risk investments and accept near-0% interest rates, or take more risk to try to generate higher yield. Faced with this choice, many have opted to do nothing. But rates on many lower risk investments, including CDs, money market funds, and short duration bonds, have moved up meaningfully in the last several years. So, if your cash has been on the sidelines, you may want to reconsider your choices.

"Many people may be leaving money on the table by not taking full advantage of the cash portion of their portfolios," says Richard Carter, vice president of fixed income products and services at Fidelity.

If you're one of them, you should consider your options for cash, including high-yield savings accounts, short-duration bonds, and CDs. While each of these options has advantages and disadvantages, Carter thinks CDs are worth a careful look now, thanks to the appealing blend of liquidity and yield across a variety of maturities.

The basics

CDs are time deposit accounts issued by banks in a range of maturities, from as short as 1 month to as long as 20 years. In buying a CD, you're agreeing to leave your money in the account for a specified period of time. In return for locking up your money for that period of time, the bank pays a rate of interest.

Insurance and yield

One of the advantages of CDs is that they pair interest payments with FDIC insurance. The insurance protects your deposit in case of a bank failure. If you buy a CD from an individual bank, the FDIC insures bank deposits up to $250,000 per depositor, per bank, per account ownership category. If you had a joint checking account, an IRA, and a savings account at a bank, your deposits could be insured for a total of $750,000. But not everyone wants to spread their money into variously registered bank accounts just to get FDIC insurance.

Brokered CDs, which are issued by banks but bought and sold through a brokerage firm, offer an alternative. The benefit of brokered CDs is that you can purchase CDs from many different banks around the country and own them in a single brokerage account. That means you may have the potential to get more of your cash covered by FDIC insurance than would be possible through a single account ownership at a single bank.

Gauging yield against time

Another benefit of a brokered CD program, similar to a bond ladder program, is that it offers multiple CDs not only from different banks but also with a variety of different maturities. This enables you to gauge the amount of yield against the length of time you wish to commit to your investment.

Generally speaking, 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. (The yield curve, as illustrated in the graph below, represents the relationship between yield and maturity.) 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.

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 2.0%. Over the course of the 3 months, you would earn $500 in interest, and if you reinvested the $100,000 principal 3 additional times over the course of a year (assuming the rates stay the same), it would return a cumulative $2,000 in interest.

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 2.0%, which would return $2,000 in interest over the 1-year time frame.

Access to your cash

The main limitation on CDs relates to liquidity, or the ability to access your money (including the cost of accessing it). If you need to get your money back before maturity, traditional bank CDs often charge a penalty that will reduce your yield and often reduce your principal. With brokered CDs, you don't have to pay a penalty to liquidate your position; instead, you may be able to sell the CD to another investor. However, you have to accept the market price for your CD and incur some costs to complete the transaction. If interest rates have increased since the time your CD was issued, you could lose money you had invested on the sale and have a lower return than you originally expected, or you might not be able to find a buyer at all.

And keep in mind that different CDs could have different bid-ask spreads: i.e., the difference between the price you want to pay for a CD and the price that a seller is willing to sell it for.

The ladder strategy

Investing in CDs, just like investing in other types of fixed income securities, involves a trade-off between yield, liquidity, and quality. A laddering strategy can help you balance your need for liquidity and yield. It can allow you to take advantage of the higher yields typically available on longer-term CDs while managing the additional liquidity risk by also investing in shorter-term CDs that will mature earlier.

Generally speaking, the longer a CD's term to maturity, the higher its yield. However, just as the yield curve between short-dated and long-dated Treasury bonds has flattened in recent months, so longer-dated CDs, at present, are also not yielding much more than shorter-dated CDs.

A typical CD ladder consists of several different rungs, each representing a CD with a different maturity. Say you build a ladder that includes CDs with maturities of 3 months, 6 months, 9 months, and 1 year. After 3 months, the first CD has reached maturity and each subsequent CD has moved down a rung on the maturity ladder (the CD that initially had a 6-month maturity has 3 months remaining; the 9-month CD has 6 months until maturity, and so on). You can then take the principal returned to you from the first maturing CD and rebuild your ladder by reinvesting that principal in a 1-year CD.

In less than a year, all the original rungs with maturities of less than 1 year will have matured and been replaced by CDs that pay the full 1-year rate. (See the graph above.) Also, a portion of your investment will continue to mature every 3 months.

"Rather than choosing whether to pick liquidity or yield, you can choose a balance of both," says Carter. "Even as the yield curve begins to flatten, a CD ladder offers a way to have some of the benefits of both shorter-term investments for greater liquidity while locking in a rate for a longer period with the longer-term investments."

The regular maturation and reinvestment of the CDs mean that your portfolio will reflect changes in interest rates. If rates were to fall, you would begin to feel the impact of that over time, but if rates increase, you would be able to take advantage once the next CD on the ladder matures. Spreading your CD investments across a number of different maturities may be a good way to hedge against interest rate risk, both in the initial investments and in subsequent reinvestments of maturing principal.

3 questions to ask before investing in a CD ladder

  1. 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 to handle an emergency.

    Read Viewpoints on Fidelity.com: How to save for an emergency
  2. What are your cash flow needs?
    Answering this question will help determine the frequency with which you would like to see your CDs revert to cash. When a CD matures, it will provide you with an opportunity to reevaluate your cash needs and investment opportunities before reinvesting in a new CD.
  3. How much liquidity risk can you take?
    Longer-maturity CDs generally offer more yield but come at the cost of 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. So, you need to figure out how much liquidity risk you can take to determine 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 strategies such as ladders—may enhance your returns over time. "Right now, people may be missing out by not taking advantage of their options," says Carter. "A CD ladder could help them earn more by making their cash work harder for them."

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