Purchasing Brokered CD’s

Updated September 2023

Interest Rate Environment

Over the last year or so, interest rates have moved from near zero (their rate since 2008) to around 5%. When interest rates are at this level (5%), it is important to take steps to maximize your interest income. This blog posts walks you through some of the ways to do this.

Betting on the Direction of Interest Rates

People may say “I know interest rates are going up” or “I know interest rates are going down” when essentially no one really knows what is going to happen to interest rates. Interest rates used to vary widely, up to around 20% near 1980, to near-zero from 2008 to 2022. But no one knows what will happen in the future, although you can get signals on the near term.

Basics of Fixed Income

Fixed income concepts related to CD’s are as follows. Brokerage CD’s are some of the simplest fixed income instruments out there in practice so they are great for folks that don’t want to dig deep into financial complexity.

1. Credit risk – the risk that the entity that you loaned the money to won’t pay you back in full. For CD’s, this risk is ZERO. Prior to 2008 I bought brokerage CD’s from Puerto Rico banks that failed and were taken over by the government and they gave me back my full principal plus accrued interest
2. Interest rate risk – when interest rates rise (say for example rates went up to 7%), the value of a CD will fall. If you have a 5% interest rate CD with a duration of 5 years and interest rates moved to 7% tomorrow, your $25,000 CD might be worth $20,000 if you had to sell it on the open market. But if you hold it to maturity, you would get your $25,000 back from the government plus annual payments of $1,250 for 5 years or $6,250 plus $25,000 or $31,250. You do have an “opportunity cost” inherent loss of what you would have gotten had you immediately sold the 5% CD (at a loss) and reinvested the remaining proceeds on a 7% CD. I personally felt the “interest rate risk” in the years after 2008 as my high yielding CD’s expired and I had to “reinvest” the money in CD’s that essentially yielded zero. In hindsight if I had perfect information I would have loaded up on the longest duration CD’s (10 years) right before 2008 and just held them until they all expired
3. Liquidity Risk – in 2008 I had some leveraged loan products (fixed income) that were illiquid meaning that I could not sell them for many years, and then only at a loss. CD’s are very liquid and a huge market and I don’t anticipate any problem selling them if you need the cash. You will have a loss or gain depending on whether interest rates have increased or decreased since you bought it
4. Call Risk – Call risk occurs when the issuer can “call” a financial instrument and give you back your money. Then you have to reinvest it presumably in a lower value security (like when all my CD’s expired after 2008 and my new CD’s returned nothing). It is easy to avoid this with CD’s by avoiding “callable” CD’s which are clearly marked

The Interest Rate Curve

It is important to understand the interest rate curve. At the short end of the curve, you have money markets and short term investments at 90 days or less. Then you have the middle of the curve, which moves from 90 days to up to 1 year out, and then you have the long end of the curve, which goes from years 2 to 10. These date ranges are arbitrary but useful for this discussion (I could have picked < 1 year, 1-3 years, and 3 years plus instead).

The traditional rate curve has lower interest rates in the nearest periods and the highest interest rates in the longest period. For example, short term rates might be 3% / year and long term rates might be 6% / year. This would represent a “traditional” yield curve with expectations of higher interest rates in future periods.

In an “inverted” yield curve, the market expects interest rates to drop, and so you might have 5% in the short term and 3% in the longest duration (10 year) CD’s.

The current yield curve is very “flat”. This means that the current month is not far from the longest date on the curve. The current month has 5.40% interest and the 10 year CD has 6% interest rates. That is a very flat yield curve.

Savings Accounts

Savings accounts are typically a flat rate. Since 2008, savings accounts have had very low interest rates, effectively near zero. Recently, many banks offer high yield savings accounts, which could promise yields of up to 5%, often up to a certain dollar amount (maybe $10,000)? Also these savings accounts don’t promise to pay for a long time – if interest rates drop, I would expect these “high yield” accounts to quickly drop the rates that they pay customers.

Money Market Accounts

Money market accounts are tied to short term interest rates. Thus right now money markets yield near 5.3% (5.28%, see screen shot below). Unlike banks, if you have money sitting in your brokerage account, it is earning the same as short term rates (less a small percentage for expenses). However, if interest rates go down, this money market rate will go down right with those rates. If we went back to a zero interest rate environment (like we had from 2008 – 2022) then you get no interest income on your money market. If you believe that interest rates are going to go up, however, parking funds in money markets is a great place to be because you automatically earn more interest income as the rates go up and you aren’t locked in.

Traditional CD’s from Banks

Your bank may offer you a CD. For instance, if you bank at JP Morgan, they might offer you a CD next to your check and savings account. Often this CD will be for a rate less than the rate curve – the curve for a 1 year CD might be 5.2% and they might offer you 3%. To bank would prefer that you leave your deposits in the zero interest rate checking account, but if needed they would be OK with you buying a CD from them that is lower than the yield curve. Traditionally (until maybe 20 years ago), you got a CD by going to the bank and signing a piece of paper with unique terms. And your bank would only sell you a CD from themselves (JP Morgan would not sell you a Citigroup CD, or at least that wasn’t common).

Brokerage CD’s

A better way to do this is to buy CD’s from a brokerage like Vanguard, Fidelity, eTrade or Schwab. Most brokerages offer this service.

You can buy either NEW or EXISTING (previously issued) CD’s from a wide variety (hundreds) of US banks. To keep this article simple, I am going to assume you only buy NEW CD’s (buying existing CD’s will have gains or losses since you are buying above or below par, so since you can get the same net result I recommend just purchasing newly issued CD’s).

A CD “Ladder”

The easiest way to invest in CD’s is to make a “ladder”. A ladder will take some of your money and invest it in short term CD’s, some of your money and put it in mid term CD’s, and the rest in long term CD’s.

Note that money in your “money market” account is essentially a short term CD. Let’s say for instance that you want to invest $100,000 and the yield curve looks like the curve up above in the article.

1. Money Market – you can leave $25,000 in your money market account. This is essentially the shortest duration CD. If interest rates rise significantly, this money can be put back into the market. If rates go down, you get the current rate (which would be lower than 5%, say 3%)
2. Short duration CD – you can put $25,000 in an 18 month CD
3. Mid-duration CD – you can put $25,000 in a 4 year CD
4. Long duration CD – you can put $25,000 in a 7 year CD

Once again you can vary these date ranges if you want – your long duration CD’s could be 10 years, your mid-duration CD’s could be 5 years, etc… these are just indicative ranges.

How To Invest In Brokerage CD’s

Move your money into your brokerage account from your bank. It will go into a money market account.

Then follow their prompts on how to buy a CD. The CD’s are usually split by duration. For instance you can say you want a 5 year CD.

Buy the new issue CD’s. There are no gains or losses on newly issued CD’s which makes it easier.

When your list of 5 year CD’s come up, choose a security. You want to avoid the callable CD’s.

If two CD’s both yield 5%, for instance, then you will want to choose the one with the more frequent payments. A semi-annual coupon is worth more than an annual coupon, and a monthly coupon is worth more than a semi annual coupon, all else being equal. This is due to the fact that you earn “interest on interest” and as rates get higher, this becomes more and more meaningful.

Securities are usually bought in units of 1000 dollars. To buy a $50,000 CD, put in 50.

Here is a link to a video from Vanguard (your brokerage firm will have its own specific instructions that explains it too.

Banks and FDIC Limits

Limits are $250,000 for each bank. If you have a lot of money to invest and hold assets jointly, you can each own $250,000 for a total of $500,000.

For practical purposes, since you are choosing from essentially all banks in the USA that are issuing new CD’s, just choose banks and put up to $250,000 in CD’s at each bank. This will make it simple. And include any other investments you have in the bank into that calculation (checking, savings, etc…).

Once again, since you are buying from every bank in the USA, this is not really a problem if you just spend a few extra minutes looking at the list of banks and your choice of duration (how long), payment period (annual, semi-annual, monthly) and rate. Buy new issues and avoid callable CD’s.