Is it time to look at CDs?

If you've been ignoring your cash holdings, you might be missing opportunities for higher yields.

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Investors sitting on cash have faced a dilemma in recent years. They could choose stable, low-risk options and accept near–zero percent interest rates, or take more risk to try to generate higher yield. Faced with this unpleasant choice, many have opted to do nothing.

“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 certificates of deposit (CDs). While each of these options has advantages and disadvantages, Carter thinks CDs are worth a careful look now, thanks to the variety of maturities and the appealing blend of relative safety, liquidity, and yield.

The basics

CDs are time deposit accounts issued by banks in a range of maturities, from as short as one 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 would be insured for a total of $750,000. But not everyone wants to spread their money into variously registered bank accounts simply to get FDIC insurance.

Brokered CDs, which are issued by banks but bought and sold through a brokerage, offer an alternative. The benefit of brokered CDs is that you can pick your CD from banks around the country to be owned in one 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 bank.

Higher yields

As of May 24, a three-month Treasury yield was 0.31%, while a three-month CD yield was 0.45%. The average savings account had an interest rate of just 0.06%, though some high- yielding accounts, which may come with certain account minimums, maximums, transaction requirements, or service restrictions, had an interest rate of about 1%.1

What does that extra yield translate to? Let’s say you invested $100,000 in three-month CDs with a yield of 0.45%. Over the course of the three months, you would earn $112 in interest, compared to $77 in a Treasury. Savers willing to lose a bit of liquidity could buy a three- or five-year CD to get additional yield. As of May 23, the highest-yielding five-year CD on Fidelity.com had an expected yield of 1.6%. For three years, the highest yield was 1.25%.

Access to your cash

The main limitation on CDs relates to liquidity, or the ability to access your money. 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.

The ladder strategy

Investing in CDs involves a trade-off between yield and liquidity. The longer a CD’s term, the higher its yield is likely to be, but the more time you’ll have to wait to receive your principal. A laddering strategy can help you balance your need for liquidity and yield. It can allow you to take advantage of the higher yields available on longer-term CDs while managing the additional liquidity risk by also investing in shorter-term CDs that will mature earlier.

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 three months, six months, nine months, and one year. After three months, the first CD has reached maturity and each subsequent CD has moved down one rung on the maturity ladder (the CD that initially had a six-month maturity has three months remaining; the nine-month CD has six months until maturity and so on). You can then take the principal from the first maturing CD, keep the interest, and rebuild your ladder by reinvesting the principal in a one-year CD.

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

“Rather than choosing whether to pick liquidity or yield, you can choose a balance of both,” says Carter. “A CD ladder offers a way to have some of the benefits of both shorter-term and 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, but if rates increase, you would be able to take advantage once the next CD on the ladder matures.

Three questions to ask before investing in a CD ladder:

  1. How much cash do you need?
    Carter suggests thinking of a CD allocation as a middle ground between your investments and the highly liquid cash investments that you may need for daily expenses or to handle an emergency.
    Read Viewpoints: "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. 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.”

Learn more

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1. Source: iMoneyNet, as of March 11, 2016.
Money market funds seek to preserve the value of your investment at $1 per share, and, while they are among the most conservative investment options, it is possible to lose money by investing in such funds. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
Information provided in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. The views and opinions expressed by the authors are their own as of March 11, 2015, and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions. Fidelity Investments disclaims any liability for any direct or incidental loss incurred by applying any of the information in this article. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing these investments by making this article available to its customers.
Consult your tax or financial advisor for information concerning your specific situation.
For the purposes of FDIC insurance coverage limits, all depository assets of the account holder at the institution that issued the CD will generally be counted toward the aggregate limit (usually $250,000) for each applicable category of account. FDIC insurance does not cover market losses. In some cases, CDs may be purchased on the secondary market at a price that reflects a premium to their principal value. This premium is ineligible for FDIC insurance. For details on FDIC insurance limits, see www.fdic.gov.
Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Your ability to sell a CD on the secondary market is subject to market conditions. If your CD has a step rate, the interest rate of your CD may be higher or lower than prevailing market rates. The initial rate on a step rate CD is not the yield to maturity. If your CD has a call provision, which many step rate CDs do, please be aware the decision to call the CD is at the issuer's sole discretion. Also, if the issuer calls the CD, you may be confronted with a less favorable interest rate at which to reinvest your funds. Fidelity makes no judgment as to the credit worthiness of the issuing institution.
Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, and instrumentalities is generally exempt from state income tax but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.
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