Callable Certificate of Deposit (CD)

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. This is most often done when interest rates move lower, allowing the issuing bank to stop paying CD holders higher than the prevailing rates.

Due to the possibility of the CD being called before maturity, which would result in a loss of interest earnings and which poses reinvestment risk, interest rates on callable CDs are usually higher than those for regular CDs.

Understanding a Callable CD

A callable CD has two features: a certificate of deposit and an embedded call option owned by the CD issuer. An issuer will typically seek to call back CDs when interest rates fall, since this will prevent the issuer from paying fixed interest that is higher than the prevailing market rates.The bank may then re-issue new CDs with lower interest rates.

A CD is essentially a time deposit issued by banks to investors, who purchase CDs to earn interest on their investment for a fixed period of time that may be higher than interest paid on demand deposits. These financial products pay interest until they mature, 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 because the funds are less liquid, but is also considered a low-risk investment as it is usually 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.

Special Considerations

The call premium is the amount over the par value of the CD needed to compensate investors for the risk of being called away, and it typically decreases as the CD nears its maturity date. It is typically priced as an increase in the CD's yield to investors, and is clearly disclosed in the disclosure statement that stipulates the terms of the CD to potential investors.

The call date is the date up until which the bank can call back its outstanding CDs, 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.

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.

Bottom Line

Callable CDs shift the interest rate to you from the bank. For the higher risk, you'll tend to receive a higher return than you'd find with a traditional CD with a similar maturity date. Before you invest, you should compare the rates of the two products. Then, think about which direction you think interest rates are headed in the future. If you have concerns about reinvestment risk and prefer simplicity, callable CDs probably aren't for you.