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 Z% in interest rate payments that pay 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.
CDs are considered conservative investments and the likelihood of getting your money back is very high. Many CDs are FDIC insured making them safe investments. If the bank goes belly up the FDIC insurance will make you whole for up to $250,000 per institution per ownership category. If you’re going to invest more than $250,000 you may want to consider using alternate banks or account types.
How to Calculate CD Rates
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 or QE.
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 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 and spending from consumers and businesses.
Rates Going Forward
Markets can change fast. If we compare the last couple years to 2022 there has been drastic change. In 2020 and 2021 the Federal Reserve was keeping rates low as a result of COVID to encourage spending. Rates were near zero. This year has been a completely different story. The Fed has been increasing rates to combat inflation. You can now get CDs paying in the 4% range.
These conditions can be worrisome but I’d be less concerned about an increase in interest rates and more concerned about your overall investment portfolio. Focus on the big picture over the long term. As rates increase it can negatively impact fixed income holdings and one needs to be cognizant of this. That said, how you are invested overall for retirement is much more important.
An increase in rates will put downward pressure on any marketable 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.
Should You Invest in CDs?
CDs can be appropriate depending on your expectations and need from the portfolio.
The big issue right now is rising interest rates. In my opinion, it may make sense to invest in shorter term CDs while interest rates are increasing. This can help with volatility and you will likely receive higher interest payments than a savings account.
You can then review your portfolio to see if extending your maturities makes sense, once interest rates calm down or as current holdings mature, or invest in a more aggressive bond portfolio.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
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