It's no coincidence that inflation rates and current CD rates are at levels not seen in years. Rising inflation usually means higher interest rates are headed our way to combat the increasing prices. The Federal Reserve's (The Fed) primary tool to fight inflation is raising the interest rates that member banks charge each other to borrow money. This is called the Fed-funds rate. Once the cost of borrowing goes up for one bank, they will charge their customers a higher rate to maintain profit margins, and those customers will charge their customers higher interest, and so on. During rising rates, you should see an increase in all types of credit, from commercial lending to mortgage, auto, and personal debt. The money supply eventually decreases because of the increased borrowing costs, and prices are expected to fall due to lower demand.
The cost of borrowing for banks increases with higher interest rates. Therefore, they must offer higher rates to depositors, and many banks offer Certificates of Deposit. A certificate of deposit (CD) is a savings account that holds a fixed amount of money for a fixed period, such as three months, six months, one year, or five years, and in exchange, the issuing bank pays interest. It may be time to consider adding CDs to the conservative side of your portfolio.
The Benefits of a CD:
CDs are federally insured by the Federal Deposit Insurance Corporation (FDIC). The maximum amount is $250,000, per depositor, per insured bank. For example, Mr. X can have more than one account, but the aggregate total at that bank is $250K. Mr. X can deposit funds above $250K into another bank or open another account at his existing bank under a different entity, such as a trust. Note that a joint account is FDIC insured up to $500K.
Here are ways you may be able to insure more than $250K in deposits:
- Open accounts at more than one institution. The strategy works as long as the two institutions are distinct.
- Open accounts in different ownership categories (trust, business, or other family members).
- Open a brokerage deposit account (i.e., TD Ameritrade, Fidelity, etc.).
- High Current Yield/Low Risk
The interest rates on CDs with maturities ranging from three to twelve months are reaching 5% and more - a vast difference from rates below .40% that existed from 2009 to 2022. An added benefit is the default risk of CDs insured by the FDIC (see "safety" above) is extremely low. As we see in the current banking environment, the amounts above the guaranteed threshold are the subject of great concern in the banking industry.
CDs and other cash alternative investments (including money market funds) are traditionally part of the conservative side of an investment portfolio but have never been a serious contributor to higher returns in an overall portfolio because of minuscule rates over the past two decades. When you hear the phrase "60/40" portfolio allocation, it usually means that 60% of the portfolio is invested in the riskier asset classes, including stocks, real estate, and commodities. The "40" in the ratio represents the less risky bonds and cash held in a portfolio. CDs would then be a part of the "40" in the 60/40 ratio. The bonds in a portfolio could include the following:
Short-term Gov't Bonds
Long-Term Gov't Bonds
Investment Grade Corporate Bonds
High-Yield Corporate Bonds
Inflation Protected Bonds (TIPS)
Comparing an average return for the total bond market to the current CD rates would be helpful to determine if allocations to CDs make financial sense. Bloomberg's Aggregate Bond index tracks the aggregate return of all investment-grade bonds traded in the U.S.
The annualized return for the Bond index through Dec 31, 2021, is shown below:
Bloomberg's Aggregate Bond Index¹
(Through Dec 31, 2021)
Five years 3.6%
Ten years 2.9%
20 years 4.3%³
40 years 7.4%
For example, from 2012 to 2021, the annualized weighted average return for the entire investment-grade bond market in the U.S. was 2.9%. In 2022, the loss was -13.0% for the aggregate bond index. The current return on a 30-day CD ranges from 4.75% to 4.90%². A five-year CD is available at 4.75% to 4.85%² (see current rates below). In other words, the return from "cash (CDs)" for the next 30 days or the next five years is higher than the aggregate return of the bond market for the past 20 years (³4.3% through Dec 2021). See the current returns of CDs with different maturities below. Of course, rates on CDs will eventually fall once the Fed begins to lower the Fed Funds rate because of lower concerns about inflation. Once rates drop low enough, a reallocation to a mixed portfolio of bonds may make sense.
¹ Indices are not available for direct investment; therefore, their performance does not reflect the expenses of managing an actual portfolio. The returns of indices presented herein reflect hypothetical performance and do not represent returns that any investor actually attained.
² Rates offered by various banks through TD Ameritrade Institutional@ 3/22/2023.
- Strategy to ladder CDs
The difference in rates between a 3-month CD and a 12-month CD may be minimal, but the objective is to earn a higher return for as long as possible and try and avoid locking in a rate for too long a period when rates are going up. Staggering CD maturities can provide the opportunity to reinvest quicker into higher rates and, at the same time, lock in longer-term rates to protect against rapidly falling interest rates.
For example, suppose an investor has $100K sitting in a low-interest savings account or non-interest-bearing account. The investor feels the rates will continue to rise for a few more months and eventually decline to 2% or less in twelve months. Assume the rate on the 3-month CD is 4.80% and the 12-month CD is 5.20%. A recommendation would be splitting the $100K into two separate investments, one for three months, which may allow the rollover into higher rates, and another for 12 months, where a higher rate will be paid even if interest rates fall within the following year.
The risk associated with owning CDs involves:
- Interest rate risk is the risk that rates will increase while holding CDs. The cost here is the opportunity cost only since higher rates will not lower the value of short-term CDs. Whereas longer-term bonds can lose value when interest rates rise (this is happening in the current banking crisis). See my blog: "Silicon Valley Bank - Guilty of Being Too Conservative."
- Penalty for early withdrawal – Make sure you allow the CD to mature; otherwise, there is a penalty (3 mos. Interest and more depending on the term of the CD) if you withdraw before maturity.
- Negligible credit risk - Amounts above the $250K insured threshold (see above how to increase $250K) are technically not insured. However, because of the detrimental impact that defaults would have on our debt-charged banking system and the fact we can just print money if needed, the fear of someone losing their funds in the country's banking system may be overdone.
Current Rates Available (Bank CDs through TD Ameritrade Institutional @3/22/2023)
Maturity Rate (range)
30 days (one month) 4.75% to 4.90%
Three months 5.00% to 5.05%
Six months 5.00% to 5.15%
One-Year 5.00% to 5.25%
Two-Year 5.00% to 5.05%
Five-Year 4.75% to 4.85%
If you have cash earning meager savings rates or sitting idle, converting to CD would make sense, provided the funds can remain in CD throughout the term. But what if you are interested in reallocating a portion of other investments like stocks and bonds to CDs?
Converting other bond investments to CDs will most likely lower the overall portfolio risk because of the FDIC insurance and the reduction of interest rate risk due to other longer-term bonds being sold. On the other hand, transaction costs will be incurred for sales and the lost opportunity to make expected gains when interest rates eventually decrease (for longer-term bonds, they can go up when rates rise just as fast as they went down went rates increased).
Converting equity and other higher expected return asset classes to CDs would change your portfolio's risk/return composition, which ultimately determines the expected future returns. In addition, taxes need to be considered. A qualified account (IRA, 401K, etc.) would not recognize any taxes on sales within the account. On the other hand, A non-taxable account (brokerage, trust) will realize capital gains (or capital loss). The value of financial advice and a well-thought-out financial plan designed to periodically be updated to ensure you are on the right path to reach your financial objectives is evident in these situations where sources of knowledge and personal service are efficiently available.
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Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. Diversification neither assures a profit nor guarantees against loss in a declining market. There is no guarantee that strategies will be successful.