Are CDs a Good Investment in 2021?

A big concern for investors right now is interest rates or lack thereof. When an investor used to have a lump sum of money one of their first thoughts was to visit a bank and get a CD. It made sense 30 years ago, but not so much today.

The point of buying a CD is that you receive interest over the term of issuance. This used to be around 5% or in the 80’s it was 10% or more. That’s a pretty solid deal if you don’t need the money over the proposed time frame.

Today this is a different story. Interest rates are STILL at an all-time low. They have been for the past ten years. They’re close to 0% currently if you’re looking at the current CD rates.

If you look at Japan or Germany interest rates have gone negative. This means you’re paying the bank to borrow your money because you think it’s better than a savings account. In this article, I explain the breakdown of CDs and their purpose in a portfolio.

What is a CD?

CD stands for a certificate of deposit. They are typically issued by a bank or government institution such as the United States Treasury Department.

CDs function similarly to individual bonds. You can buy a CD for X amount of dollars for Y amount of time and receive a Z interest rate that pays out on a periodic basis. They are debt instruments, meaning you are loaning someone money to receive a fixed income.

Basically, you’re letting someone rent your money. Think of yourself as a bank. Some institutions will pay you more than others to borrow your money. This is because some institutions are more stable, or credible than others. You have a higher likelihood of getting your money back.

CDs are considered conservative investments and the likelihood of getting your money back is very high. Some CDs are guaranteed by the government such as treasuries so this is considered a risk-free rate. Banks also issue them and they are still considered low-risk debt instruments hence their extremely low-interest rates.

The relationship between risk and reward dictates your expected rate of return with any investment. CDs are in a tough place at the moment in my opinion. This is because you have to lock up your money for the duration of the term and you could be penalized if you take your money out before the maturity date while receiving little interest in the first place.

How to Calculate CD Rates

CD Example:

ABC Bank issues a CD for $10,000 for a 5-year term at a 5% interest rate that is paid semi-annually.

You would give the bank $10,000 and you’d receive $250 every six months totaling $500 each year. This is the 5% interest rate paying out. You would have the CD for 5 years and once the term expired you would get your initial investment back of $10,000.

This is a basic example. There can be CDs that are callable and you can calculate different returns like yield to worst and yield to maturity to help you understand your best and worst-case scenarios. A bond can be callable before the maturity date.

You can also buy marketable CDs which will fluctuate in value depending on current interest rates. In a changing interest rate environment, you will likely buy the CD at a premium or discount.

The issuer will sell the CD at a certain amount and then it will trade in the market at or below this price. This is because you can go out into the market and buy a current CD with a lower or higher interest rate thereby increasing or decreasing the value of the CD.

Regardless if you buy at a premium or discount you will get par value back at the maturity date. Par value is the amount the CD was originally issued at.

Are CD Rates Going Up?

History of Interest Rates

In order to answer this question let’s look back at historic interest rates. The Federal Reserve is responsible for setting and maintaining the monetary policy. They set interest rates for banks to borrow from them also known as the discount rate.

The Fed meets eight times a year to discuss economic conditions and determine if there should be any changes to monetary policy. This can include raising or lowering rates or buying bonds to help stimulate the economy as in quantitative easing.

For the past 10 years, interest rates have been the lowest in history. The reasoning for this is because of the Great Recession. In order to combat this, the Fed lowered rates and started the QE (quantitative easing) process where they were buying billions of dollars worth of bonds.

This was to help stimulate the economy because they were pumping money into the financial system making it cheaper and easier to get. Therefore, when more money is available this encourages productivity around spending both from consumers and businesses.

The Federal Reserve announced last year in September that they do not plan to raise interest rates until 2023. They plan for rates to stay stable until then. The reasoning behind this is COVID-19 and the uncertainty of economic recovery therefore keeping rates low will help consumers and business owners spend more money, in theory.

Rates Going Forward

You can only take what the Fed says with a grain of salt. They could change their mind the next time they meet. That said, when they started raising rates in recent years in 2015 through 2018 they only were raising them by 0.25% each quarter, so it’s not necessarily a huge increase.

I don’t expect rates to stay level this year and into 2022. Once the COVID-19 vaccine has been fully rolled out they will start to consider increasing them. Any increase will be gradual over time.

I’d be less concerned about an increase in interest rates and more concerned about your overall investment portfolio. An increase in interest rates will likely not be very material. How you’re invested overall for retirement is much more important.

An increase in rates will put downward pressure on your CDs. This is because an uptick in rates makes your CD less valuable due to its lower rate. A buyer can go out and get a CD that pays a higher interest rate. This makes your CD less attractive.

Interest rates will have to go up at some point so expect an increase in the coming years. Time will tell when this will happen. I believe once the economy gets back on track the Fed will entertain the thought. Increasing rates along with inflation are signs of a healthy economy. We can expect these things to happen as we get back to full employment.

Should You Invest in CDs?

Interest Rates:

CDs can be appropriate depending on your expectations and need from the portfolio.

The BIG issue right now is low-interest rates. In my opinion, it’s hard to justify investing in CDs in the current interest rate environment. We’re talking less than 1% to 2% on short to mid-term CDs with maturities between 0 and 10+ years.

They are very conservative, so you may want to look into taking on more risk and considering corporate bonds. Even then yields are not much better right now.

When Do CD’s Make Sense:

The appropriate situation is largely dictated by interest rates as previously stated. This is what will determine if CDs are a good investment or not. Usually, they will be used in conjunction with other investments in an overall larger portfolio.

They can make sense in certain cases – for example, when used as a smaller percentage of a portfolio to help with diversification and provide insulation from the stock market.

Looking for other investment opportunities for your portfolio? Check out my post on individual investing in private equity.

If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER, at Applied Capital. Email him at [email protected] or fill out a contact form.

This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.

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