Will 2014 Mark The Return Of The CD?

By Investopedia | July 22, 2013 AAA

By Richard Barrington

Low interest rates have made recent years a bleak time for certificates of deposit (CDs). But as interest rates start to rise, expect CDs to gain new life. In fact, if bank rates follow the pattern that yields in the bond market have already begun to set, CD rates may be the first deposit rates to benefit from rising interest rates.

The turnaround in rates

In the bond market, the rise in interest rates has begun in earnest. Rates began to rise in May, and then rose more sharply in June, with longer-term bond yields rising much faster than short-term yields. From May 1 to July 5, 30-year bond yields rose by 85 basis points. The increase in one-year bond yields over that same period was just four basis points.

Expect banks to protect their profit margins by being slower to raise deposit rates. But when rates do start to rise, don't be surprised if they follow the pattern of the bond market, with longer-term rates, such as five-year CD rates, rising the fastest.

Strategies for capturing higher CD rates

Just as interest rates fell steadily over a period of a few years, once rates start to rise it may take some time for them to continue their climb. Therefore, at this time it's not so much a question of planning for a higher rate environment, but for a dynamic rate environment in which rates are moving higher. Here are some strategies for getting the most out of CD rates as they climb:

  1. Lengthen as rates rise. Your initial strategy should be to keep CD maturities short, so you can roll over frequently as rates rise. Then, once CD rates do start to rise, you can gradually move to longer and longer terms.
  2. Watch the spread. Chances are, when CD rates rise they won't move uniformly across the board. If CDs follow the pattern of the bond market and longer rates start to rise first, this might speed up your move into longer-term CDs.
  3. Shop for each CD separately. Don't automatically assume each CD you pick should all be with the same bank. There's not much interaction involved with these accounts, so there isn't much less convenience to having multiple CDs spread across different banks. Spreading CDs around will allow you to shop for the best rate on the market each time, and for larger depositors it will help keep total deposits at any one bank below the $250,000 FDIC insurance limit.
  4. Look for low early withdrawal penalties. These penalties are normally based on a few months' worth of interest, so the one advantage of a low rate environment is that it often translates to low penalties for early withdrawal from a CD. A low penalty on a longer-term CD is one way to capture a higher rate initially, but still have a hedge against rising interest rates.
  5. Roll over carefully. Too often, people allow their CDs to roll over passively. Especially in a dynamic rate environment, you will want to choose your CD length and shop for banks actively each time you reinvest your CD proceeds.

Rising interest rates can make choosing CDs a little trickier. But after a sustained stretch of sub-1 percent CD rates, depositors will welcome the challenge once rates finally start to rise.

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