After nearly a decade of rock-bottom interest rates, the certificate of deposit (CD) is suffering from reduced demand. You remember CDs—those plain-vanilla, timed bank deposits that pay a little rent for stashing your savings out of sight and away from riskier market whims.
With the Federal Reserve leaning toward inching its benchmark interest rate up for real this year—assuming China’s recent devaluation of the yuan hasn’t thwarted those plans—CDs could once again curry investor favor.
“In our world, the CD is basic investing,” says Craig Laffman, director of fixed income and syndicate at TD Ameritrade. “When rates go up, there should be an effect across all fixed income products.”
Of course, it’s not that simple. “From there, rates are relative with respect to risk, maturity, and asset class,” he adds. Investors turn to fixed income investing, including bonds and CDs, for regular income, diversification, and capital preservation. But fixed income across asset classes is not free from risk, leaving investors to weigh whether rates are compensating for that risk.
CDs have been losing popularity steadily since 2004, when 16.1% of all families in the U.S. held one, according to the Federal Reserve’s Survey of Consumer Finances. And that was before interest rates plummeted to near zero.
By 2013, the latest figures available, that number was nearly halved, with just 7.8% of families invested in a CD. One culprit, of course, is low yields over this period, demoting the hands-off-but-higher-rate CD advantages over simple transaction accounts like savings, checking, and money markets.
There are essentially two types of CDs: Bank CDs that need to be held at the issuing institution, and brokered CDs, which can be held at any broker dealer (including TD Ameritrade). Brokered CDs have liquidity similar to traded bonds, with secondary prices determined by the overall market interest rate environment.
Fixed income investments including bank-issued CDs generally pay more than interest-bearing savings accounts. Why? Because there’s a penalty for pulling the money out before it reaches maturity. Deposits provide the bank with a steady source of money it can recirculate in loans. Savings and checking accounts, on the other hand, are more liquid for the account holder. Like your savings account, CDs are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), which means they’re covered even if the bank holding them fails.
Rates, of course, vary depending on the needs—or should we say the neediness—of the banks and the maturity of the CD. “This is a marketplace driven by the funding needs of the bank, and that’s what drives the aggressiveness of rates in the marketplace,” Laffman says.
Higher Rates: When, Not If
“There’s not anything that’s mind-blowing with respect to the rate right now,” says Laffman.
Nor has there been since 2008. The average rate on one-year CDs is about 0.27% in August 2015—and has been for more than five months. It’s about 0.87% for five-year CDs going on two months now. Rates tend to be higher at online banks than at brick-and-mortar branch banks simply because the overhead is less and they can pass the cost savings down to customers. But the rate you get on a savings account anywhere is far lower, averaging a paltry 0.06% in summer 2015, according to the FDIC.
“Today’s rates are where they should be based on the climate that we’re in and the artificial activities that the Fed has taken to reduce the yield, but it doesn’t stop the funding needs of a bank,” Laffman says.
Remember, too, that CDs are potentially a good alternative to help offset volatility in your retirement portfolios. Some money experts even think you should look to CDs as a low-risk, interest-paying savings vessel rather than using a transaction account for, say, a vacation or a kitchen renovation.
“This [interest rate hike] has been kind of a broken-record conversation for some time,” Laffman says. “Everyone is waiting for rates to rise. It’s a function of when now, not if.”
And when the Fed does move, most analysts think it can react slowly considering low inflation and sub-par economic growth.
Until then, investors might research fixed income maturities that make the most sense in the interest rate environment we’re already in.
"We are encouraging fixed income investors to evaluate their holdings and reposition in advance of the rate hike cycle," says Laffman.
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