DEFINITION of Callable Certificate Of Deposit
A callable certificate of deposit is an FDIC insured certificate of deposit (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.
BREAKING DOWN Callable Certificate Of Deposit
A callable certificate of deposit has two features – A CD and a callable security. A certificate of deposit, or CD, is a time deposit issued by banks to investors who purchase the 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 or depositor can access his or her 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, especially during times of decreasing interest rates which allow the borrower 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 are often redeemed at a premium to their purchase price as an incentive for investors to take on the call risk associated with the investment.
For example, 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 1% higher rate for the duration of the CD. By using a callable CD, the bank can refinance its existing CDs by paying a call premium to investors and reissue the CD at a 3.5% yield.
The call premium is an amount over the par value of the CD, and typically decreases as the CD nears its maturity date. The call premium is stated in the disclosure statement which stipulates the terms of the CD including the call date. The call date is the date the bank can call back its shares. In our example above, if the bank issued a CD to mature in 2 years but set its first call date after six months from the date of issuance, the bank will not be able to retire its CD within the first six months of the bond’s term life. This lockout period provides a guarantee to investors that interest will be paid for at least six months before the CD can be redeemed.
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 lower interest paying CD.