✔ CDs may offer higher yields than savings accounts and Treasuries.
✔ Brokerage CDs may provide FDIC insurance on a higher balance than 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 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. But rates on many lower risk options, including CDs, money markets, and short duration bonds, have moved up meaningfully in the last year. So, if you have been on the sidelines, you may want to reconsider.
“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.
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 could 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 many different 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.
As of July 6, a three-month Treasury yield was 1.05%, while the highest yielding three-month CD on the Fidelity platform was 1.2%. 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 a three-month CD with a yield of 1.2%. Over the course of the three months, you would earn $299 in interest, compared to $261 in a Treasury. Savers willing to lose a bit of liquidity and accept a bit of rate risk could buy a three- or five-year CD to get additional yield. As of July 6, the highest-yielding five-year CD on Fidelity.com had an expected yield of 2.3%. For three years, the highest yield was 1.85%.
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:
- 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.
- 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.
- 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.”