What Is a Callable Certificate of Deposit (CD)?
A callable certificate of deposit (CD) is an FDIC-insured CD that contains a call feature similar to other types of callable fixed-income securities. Callable CDs can be redeemed (called away) early by the issuing bank prior to their stated maturity, usually within a given time frame and at a preset call price. Due to the possibility of the CD being called before maturity, which would result in a loss of interest earnings, interest rates on callable CDs are usually higher than those for regular CDs. Nevertheless, it is wise to read the fine print before investing in a callable CD.
- A callable certificate of deposit (CD) can be redeemed prior to maturity at a preset price.
- A bank might choose to issue a callable CD so that it is not stuck paying higher interest for the term of the CD when interest rates drop.
- Usually there is a preset call premium that the bank will pay when choosing to call a CD for redemption, which is intended to ameliorate the risk to investors of losing the higher interest rate.
Understanding a Callable CD
A callable CD has two features: a CD and a callable security. A CD is a time deposit issued by banks to investors, who purchase CDs to earn interest on their investment for a fixed period of time. The financial product pays interest until it matures, at which point the investor can access the funds. Although it is still possible to withdraw money from a CD prior to the maturity date, this action will often incur an early withdrawal penalty. A CD typically offers a higher rate of return than a standard savings account and is considered a risk-free investment insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA).
A callable security is one that can be redeemed early by the issuer, allowing the issuer to refinance its interest-bearing securities. A bank adds a call feature to a CD so it does not have to continue paying a higher rate to the CD holder if interest rates drop. Callable CDs often pay a call premium to the investor when redeemed early, as an incentive for investors to take on the call risk associated with the investment.
The call premium is an amount over the par value of the CD, and it typically decreases as the CD nears its maturity date. It is stated in the disclosure statement that stipulates the terms of the CD. The call date is the date the bank can call back its shares, and it is also included in the disclosure statement.
The addition of call provisions to CDs creates reinvestment risk to investors. This is the risk that the time deposit may be retired early, forcing the investor to reinvest his or her proceeds in a CD paying lower interest.
The amount of the call premium usually shrinks as the maturity date of a CD draws closer.
Example of a Callable CD
If a bank issues a traditional CD that pays 4.5% to the investor, and interest rates fall to a point where the bank could issue the same CD to someone else for only 3.5%, the bank would be paying a 1% higher rate for the duration of the CD. By using a callable CD, the bank can choose to refinance it and reissue a new CD at a 3.5% yield.
If the bank issued the callable 4.5% CD to mature in two years but set its first call date after six months from the date of issuance, it will not be able to retire its CD until those six months have gone by. This lockout period provides a guarantee to investors that 4.5% interest will be paid for at least half a year. Should the bank decide to call the CD at that point, the loss of the higher interest rate will be somewhat ameliorated by the lump-sum call premium the bank pays to the CD holder.