Certificates of Deposit

If you are looking for zero risk alternatives for cash the only options essentially are US Government securities (Treasury bonds, etc…) and FDIC secured cash which consists of bank deposits (up to the limit) and certificates of deposit (CD’s). The third option is a money market account which only rarely “break the buck” lose money but it did happen recently with a fund that invested heavily in Lehman Brothers paper (other money market funds, such as those at Vanguard, state that they invest only in the highest quality paper and the likelihood of any sort of loss is very remote).

For the purposes of this post I am going to summarize up CD’s and the basics for investing in this type of zero risk security, which has changed recently. Key elements are as follows:

Principal – amount that you are investing with a financial institution – generally ranges from a few thousand dollars up to $250,000 (you can invest more but you start to go past the limits of FDIC insurance with a single institution)
Duration – CD’s range from a month to 10 years. Most common durations are 6 months, 1 year, 18 months, then 2 years, 3 years, and 5 years
Interest Rate – interest rate paid on your investment – for example 4% on $50,000 principal gives you $2000 interest / year (yes, I know it is more complicated than that). This is typically called the “nominal” rate
Payment Frequency – the most common payment frequency is monthly, quarterly, semi-annually, or annually. If two CD’s offer the same interest rate (say 4%) and one makes payments monthly and the other annually, the “effective” rate will be higher on the monthly payment because you can re-invest your interest. At the relatively low rates of interest that we are talking about (4% or so) and short durations (up to 5 years or so) and principal amounts ($100,000 or less) the difference between an annual payout and a semi-annual payout is insignificant over the life of a CD. All things being equal, if rates are the same go for the more frequent payouts
Penalty – for CD’s bought directly from institutions (i.e. your existing bank) typically there is a penalty for early withdrawal. For instance, if you have a 5 year CD and you pull out your money before the 5 year mark, then you would forfeit 3 months of interest (as an example). This process is different for CD’s bought through your brokerage account, see below.

FDIC Insurance has been changed recently. FDIC Insurance coverage has been raised from $100,000 (per individual) up to $250,000 (per individual) through December 31, 2009. This change was probably done because banks are acquiring other banks with all of the mergers and without raising this cap investors would have to pull funds out of banks in order to stay within the FDIC insurance guidelines (which would reduce the incentive for banks to acquire their weaker competitors in the first place).

Note that this change in insurance only goes through December 31, 2009 – thus if you are buying a CD in the near term with a duration longer than 12 months you should assume that this cap will go back down to $100,000 and you want to plan accordingly (i.e. don’t have CD’s > $100,000 in value with a duration past 12/31/09 in the same bank).

Purchasing a CD used to involve physically visiting a bank, transferring the funds into the bank (if your savings or checking accounts weren’t with that institution), and then receiving a statement or piece of physical paper to document your purchase. While this process certainly worked, it could also be time consuming to compare different rates and terms and it could be a hassle to track interest statements from a number of financial institutions (plus all of the extra tax forms at year end).

Today, however, a good way to purchase CD’s is through your brokerage account. If you have an account with Fidelity, Vanguard, or Schwab (for instance, there are many more) they have the ability to purchase CD’s through their “bond desk”.

You can purchase newly issued CD’s or you can purchase secondary CD’s. New CD’s are usually issued at “par” or 100 cents on the dollar. Secondary CD’s can be purchased at either a discount or a premium. Generally the discount and premium cause more complications from a tax perspective so that if all else is relatively equal new CD issues are a better and simpler bet.

For example, here is the summary at Fidelity:

Benefits of a Brokerage CD
1 All new issue CD’s offered by Fidelity are fee free
2 The CD’s Fidelity offers come from multiple sources
3 All CD’s offered by Fidelity are FDIC-insured
4 Brokerage CDs have some important advantages over bank CD’s including the ability to avoid penalties if the CD is sold before maturity

Author’s note – 2) multiple sources are useful because this allows you to select the best rate for different maturities and buy more than $100,000 at a time while staying within the FDIC limits 4) by avoiding penalties, they mean that you can sell your CD at any time at “market” price, which may be higher or lower than the current price. For example, I have a 3.5% CD that currently is priced at a discount, and a 5.3% CD that is priced at a premium. The fact that an issue is at a premium or discount doesn’t matter unless you want to sell before maturity – since I intend to hold them until maturity I am not worried about the discount. However, if you need your money back before maturity and interest rates have fallen since you purchased the CD you could actually make money (nominally) rather than pay a penalty.

Creating a “Ladder”

At the Fidelity site, for example, the new issue CD’s have different rates at different maturities. Unless interest rates are “inverted”, typically a longer duration CD would pay a higher interest rate than a shorter duration CD. From the Fidelity site:

3 month 2.10%, 6 month 2.55%, 12 month 3.2%… all the way to 5% at 7 years (84 months).

By a ladder, you might split your dollars between 1 year, 2 year, 3 year and 4 year CD’s. As each CD matures, you repurchase it at current interest rates. This will give you some protection from changes in rates, and you can protect yourself from getting stuck for a long duration at low rates (if they rise) and you can benefit for some period of time if rates decline.

If you buy this from your brokerage house (like Fidelity, or Vanguard) it is easy to select new issue CD’s from different banks that do not exceed the FDIC limits and take advantage of the best interest rates offered by CD’s at different durations. In addition, all of these CD’s appear on your brokerage statement and you get simplified tax reporting, too.

You generally will need to call the “bond desk” which is where fixed income investments like bonds and CD’s are sold. You can tell them the duration that you are looking for (2 years, for instance) and the amount you want to invest and they will tell you a bank that is offering the best rate – you will want to not put too much in any single institution. The CD’s are usually sold without extra fees (beyond whatever spread the brokerage earns from the bank, which is transparent to you).

From a tax perspective, the interest is taxable and will appear on your brokerage statement. CD’s are not necessarily tax efficient vehicles, but they are risk free. Depending on your tax bracket, municipal bonds may be a good bet, but they are more complicated and there are more risks (although municipal bonds are generally low risk, especially compared to corporate debt).

From an investment perspective, CD’s are not going to make you rich, but they won’t lose money. The interest rate is typically a bit more than the current short term rate, and then they are taxed, and the impact of inflation needs to be factored in. From an “economic” perspective, the net of return – tax – inflation is probably about zero.

Sadly enough, zero has been kicking butt for the last decade or so…

Cross posted at Life At The Great Midwest

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