Thanks to the rise in interest rates, investors have ample opportunities to get quality and high income out of their portfolios. While much attention has been placed on bonds, the rise in rates has also allowed for some traditional and safe fixed income asset classes to shine.
And this includes ‘boring’ certificates of deposits (CDs).
With rates predicted to fall and some longer-dated CDs already beginning to reflect that fact, investors looking to build a conservative income portfolio have a limited window to build a CD ladder. Now could be the best time – in a long time – to buy CDs in order to lock in 5%+ yields for the next five years.
Traditional Income Bounces Back
When the economy is moving too fast and inflation is gaining steam, the Federal Reserve raises rates to accomplish two things. One is making borrowing more expensive, which has the effect of boosting bond yields. The other is that higher rates make saving more advantageous than spending.
The second part is particularly interesting for conservative investors.
The Great Recession and its zero percent interest rates pushed rates so low that traditional and safe savings/income products – like money markets, savings accounts and certificates of deposits – paid basically nothing. At one point, savings accounts were paying as little as 0.01%. A million dollars invested at that rate would only generate $100 in interest.
However, these days, CDs, savings and money-market accounts are all paying north of 3%. For conservative investors, CDs are quite interesting in the current environment.
When you buy a CD from a bank or online, you are agreeing to leave your money in the product for a specified amount of time – this can be as little as a month or up to 20 years. In exchange, the bank agrees to pay a set coupon for the entire life of the CD. Depending on the CD, that interest can be paid at maturity or monthly. And since they are a bank savings’ product, they come with FDIC insurance.
Why Focus on CDs Today?
So, why consider CDs now? The risk/reward tradeoff has never been better. Thanks to a rise in interest rates, yields on CDs have eclipsed 5% in many cases. This allows investors to lock in a high yield and nearly equity-like returns without any risk. Remember, CDs are a savings product, so the FDIC will backstop the CD in case of a bank failure. Corporate and Treasury bonds are yielding roughly the same amount, but there is still default risk.
Current yields on CDs also eclipse rates of inflation, providing a yield advantage of ~1.5% depending on term vs current inflation readings.
The key is locking in that yield. While money markets and short-term savings vehicles may currently pay more, they carry so-called reinvestment risk, and quickly reflect changes to Federal Reserve policy. The expectation is that the Fed will cut rates sooner than later, which would instantly cut the amount of interest a savings account or money market pays. But because a CD locks in a rate for its maturity period, reinvestment risk is kicked down the road.
Now could be the time to buy CDs. This is because rates on longer-term CDs have already started to come down based on the expectation that interest rates will be cut. 5+% yields are out there, but they are less plentiful than before.
Building a CD Ladder
With the ability to lock in a risk-free 4.5%–5%, CDs are very attractive for conservative portfolios and for investors with large cash piles. With the product type once again resuming its place as a fixed income tool, exploring them for a portfolio makes sense.
However, there is one issue with CDs – and that’s their lack of liquidity. Because you are promising the bank that you’ll keep your money with the institution for a set period of time, if you need to withdraw funds, the bank will charge you a fee to gain access to those funds. Typically, it is 3 months’ worth of interest. However, with some small maturity CDs – 1, 2 or 3 months – investors may forgo all interest and receive even less than they invested.
The answer to this liquidity problem may lie within building a so-called CD ladder. Here, an investor buys a series of CDs in various maturities such as a 1-yr ladder, a 2-yr ladder and a 5-yr ladder. The idea being that each year a CD ladder will mature, and ultimately provide some liquidity. Investors can either spend the money or reinvest it into a longer-dated CD or another opportunity. This reduces reinvestment risk and locks in a higher blended yield.
For example, the following graph from Fidelity shows current CD rates as of May 21 built as three different ladders: short term, medium term and long term.
Source: Fidelity
Buying CDs is as easy as pie – you can just march down to your local bank branch and purchase one. However, that route may not be in your best interest (pun intended). By using a brokerage platform, you can have a wider choice of maturities and interest rates. Moreover, you can often buy CDs on the secondary market. Investors could possibly buy a little extra yield this way.
A word of caution no matter where you get your CD from is callability. Some CDs, though not most, come with provisions which allow the bank to return an investor’s money early on. Often, these CDs come with ‘too good to be true’ interest rates. Investors looking to lock in a high yield for a period time may be disappointed and face reinvestment risk if they choose one of these issues.
All in all, CDs make sense for conservative investors looking for a risk-free solution to providing income. Rates on the products haven’t been this good in years. The chance, however, of maintaining these yields for the long haul is slimming as the Fed gets closer to cutting rates. Building a CD’s ladder helps to eliminate the liquidity issue.
The Bottom Line
Thanks to the rise in interest rates, traditional income products are once again paying high interest. This includes certificates of deposit (CDs). CD rates haven’t been this good since before the Great Recession. Using them or a CD ladder allows investors to lock in high risk-free yields for the long haul – and they just may want to do just that.