CDs: Guess who’s back
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With its aggressive rate hikes in 2022 and continued moderate hikes in 2023, the Fed has raised rates to the point where investors can now find yield without taking on too much risk. The days of earning 0% yield on bank accounts and not much more on conservative bonds are behind us for the moment. So what does that mean for investors?
A Decade Plus of Paltry Yields
Since the Great Financial Crisis of 2008/2009, the Federal Reserve has largely kept interest rates low. Very low. The overnight Fed Funds Rate was effectively 0% from 2009 through late 2015. The Fed started to gradually hike rates in late 2015, but the arrival of COVID in early 2020 saw rates once again plummet.
With rates that low, there were few palatable options. Bank accounts largely paid next to nothing; even so-called “high-yield” checking or savings accounts offered little. Savers were left with two choices – stand pat and earn nothing or stretch for yield, thereby taking on additional risk. But the recent rise in rates gives investors more options for low-risk investing, including a once-prominent vehicle that had fallen somewhat out of favor.
Time to Look at Certificates of Deposit Again?
Many investors have used Certificates of Deposit (CDs) in their financial planning for years. They offered a safe and easy way to get a return on your money while not worrying about the return of your money, to paraphrase Will Rogers. When issued by banks, they offer FDIC insurance, a relatively short time to maturity (typically anywhere from 3 months to 5 years), and a fixed interest rate.
With rates so low for so long, the returns offered by CDs were largely unexciting. Was it worth locking up your money for a 0.5% return? Maybe, maybe not. But looking at CDs today shows a much rosier picture for investors. Pulling a list of CDs offered on the Charles Schwab website, for example, one can earn up to 5% on a one-year CD. Not bad!
That brings up an important point. Unlike the olden days when you had to physically go into a bank to purchase a CD, there is now much easier access. Online custodians like Schwab, Vanguard, and Fidelity offer CDs from multiple banks on their websites. You can build out a diversified CD portfolio with a few clicks of a button.
Some Caveats
There are a few areas to highlight concerning CDs. One is that most impose a penalty if the CD is sold before maturity. The penalty will certainly lower your return and could result in a loss. Therefore, if you buy a CD, you want to be reasonably certain that you can hold it to maturity. A CD may still be a good option, even if an early sale might be necessary. Still, it will depend on the specific circumstances (the exact penalty, the alternatives available to the CD, etc.).
Note that CDs bought through a brokerage account may be sold without penalty (though they would potentially be sold at a loss).
Additionally, if you buy CDs at your bank, FDIC insurance will only cover you up to $250,000 at that particular bank. If, for example, you buy two $100,000 CDs and keep $100,000 in your checking account, you will only have insurance up to $250,000 on your $300,000 holdings. Yes, the FDIC bumped the insurance limits for depositors in the recent mini-banking crisis, but do you want to gamble on always getting that boost?
Laddering
As with most fixed-income investments, there is interest rate risk. For example, if you buy a CD and interest rates subsequently go up, you are missing out on the higher rates until your CD matures.
One approach is to create a so-called ladder of CDs. For example, if you have $50,000 that you wish to invest, you could buy $10,000 each of 5 different CDs and stagger their maturities, e.g., have one mature in 3 months, one in 6 months, one in 9 months, one in 12 months, and one in 15 months. This gives you regular liquidity in the case of an emergency without having to sell early and incur a penalty. In this example, as each CD matures, the proceeds (if not needed at the time) can be reinvested in a new 15-month CD to maintain the ladder.
Summary
Certificates of Deposit became something of an afterthought in a zero-interest rate world. But with the recent rise in yields, they may once again be able to play an important role in your financial future.
David Crossman, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email David at dcrossman@bedelfinancial.com.