Allan S. Roth, CFP, CPA
Allan S. Roth, CFP, CPA, president of Wealth Logic, LLC, a financial advisory firm in Colorado Springs. He is author of How a Second Grader Beats Wall Street: Golden Rules Any Investor Can Learn. DareToBeDull.com
As interest rates have plunged, investments in certificates of deposit (CDs) have dropped by $800 million since 2006, or 32%. And no wonder, with one-year CDs yielding a mere 0.27%, on average…and three-year CDs averaging just 0.56%. But for investors who need their portfolios to generate income, now actually is a good time for them to consider CDs again as a safe, attractive place to stash some cash.
Reason: Once the Federal Reserve starts to push up interest rates, as it is widely expected to do later this year for the first time since 2006, bond fund performance could sink and possibly even turn negative, marking the end of the long bull market in bonds. Even individual bonds could become unattractive in cases where you have to sell them before maturity.
To squeeze the most income out of CDs (and bank accounts), you need to consider using some or all of the following strategies…
The classic CD-investing strategy in a time of rising interest rates has been to create a ladder of CDs with staggered maturity dates, typically stretching from three months to five years. That way, you keep earning interest…and as the CDs successively mature, you can redeploy the principal to pay living expenses and/or invest in new CDs, presumably at higher and higher yields. But most short-term CD yields were so low recently that a traditional ladder would produce mediocre results. The highest yields on CDs maturing in one year or less were lower than what’s available from some savings accounts, which, in contrast to CDs, allow you to withdraw money at any time without penalty.
Better: Use a barbell strategy. It gives you exposure to some of the highest yields on CDs today plus great flexibility if you suddenly need cash or when interest rates rise. With this strategy, you don’t have to guess when rates will rise or by how much.
At one end of the barbell, you keep your short-term savings (cash that you need quick access to) in a savings or money-market account at an online bank or credit union. These accounts were recently paying an annual percentage yield (APY) as high as 1.07%, better than the best three-, six- or nine-month bank CDs.
At the other end of the barbell, stash your longer-term savings (cash that you won’t need to access for a year or more) in five-year bank CDs that offer low early-withdrawal penalties. With most long-term CDs, you must sacrifice a full year’s worth of interest if you want to cash out before a CD matures to take advantage of rising interest rates. But with low-penalty CDs, you typically sacrifice just six months of interest. The highest-paying low-penalty five-year CD recently offered a 2.25% APY, only slightly lower than the 2.27% APY for the highest-paying five-year CD with a 12-month penalty—and that higher-paying CD requires a $100,000 minimum deposit.
What this means: If interest rates don’t rise or rise minimally for the next five years, you earn nearly the highest yield available. If, however, rates do rise, cashing out early doesn’t cost you too much. Example: You invest $100,000 in a five-year CD with a 2.25% APY and a six-month penalty. One year later, you decide to cash out and reinvest in a new, higher-yielding CD. After paying the penalty, you have earned $1,130 in interest (an APY equivalent to 1.13%). That’s just slightly less than if you had invested the money in today’s best-available one-year CD (1.23%). If you cash out that five-year CD in Year 2, you would earn $3,380 in interest (equivalent to a 1.69% APY, which actually is more than the best-available two-year CD now, 1.4%). Cash out in Year 3, and you would earn $5,640 in interest (equivalent to a 1.88% APY versus 1.5% for today’s best-available three-year CD). Cash out in Year 4, and you would earn $7,880 in interest (equivalent to a 1.97% APY versus 1.92% for today’s best-available four-year CD).
Helpful: Use the free online calculator at DepositAccounts.com/tools/ewp-calculator.aspx to compare early-withdrawal penalties on CDs and test what the yields would be, based on the rates being paid, the penalty and when the money is withdrawn.
If you want even higher yields and are willing to take on a little more complexity, consider a CD that is sold by a brokerage but is issued by a bank and insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor. Many brokerages offer newly issued 10-year CDs as well as older 10-year CDs that were bought by customers in the past and have less than 10 years left until maturity. Buyers of the older CDs often can get higher annual yields than with newly issued CDs.
Helpful: Right now, the highest-yielding 10-year CDs on the secondary market tend to have about nine years left before maturity. Example: I recently bought a Synchrony Bank CD on the secondary market through Fidelity Investments. It yields 3.11% and matures on July 11, 2024. That’s a far better annual yield than you can get from any bank CD, Treasury bond or even a high-quality corporate bond with a similar maturity date.
Some caveats when buying brokered CDs…
Invest only money that you won’t need back before maturity. Reason: If interest rates rise, you won’t be able to easily cash out the CD and pay a small early-withdrawal penalty, as you could with a CD bought directly from a bank. Your brokerage would have to try to sell it for you on the open market, and in that case, it would probably sell for less than you paid for it because investors presumably would have a choice of buying newly issued CDs with similar maturity dates and higher yields than yours.
Choose a large, reputable brokerage, such as Fidelity, Vanguard or Schwab—they are most likely to give you a good deal.
Make sure that your CD is “noncallable.” Banks sometimes retain the right to “call” (buy back) a CD from you before maturity if interest rates drop substantially below the rate you’re receiving. Don’t buy a CD with this feature.
To boost yields for savers, many banks are advertising “bump-up” CDs. But these CDs often are crafted to favor the banks rather than investors. Example: Bump-up CDs typically offer a lower interest rate than a comparable regular CD but allow you to raise the rate at least once if interest rates rise during the term of your CD. However, when rates rise, you don’t receive the most attractive new CD rate available. You get whatever rate your specific bank decides to offer.
For where to get the best CD and savings account rates, click here.
