Strategic Certificate of Deposit Investments

Ever since the FOMC (Federal Open Market Committee) lowered Fed Funds to be between 0.00% and 0.25%, CD rates have steadily marched downwards. For a time, 1-year CD rates hovered in the 2.25% to 2.40%. Than it was the low 2.00% and finally most have retreated to be below 1.50%. Step-ups, Bump-ups and longer-term CDs with lower early withdrawal penalties can be a good strategy to maintain some yield with out a whole lot of term risk.

Term risk is where you purchase longer-term CDs (5-years and longer) and you run the risk of rates increasing dramatically before the term expires. This can also work in the reverse where you purchased all long-term rates and they all come due in a low rate environment. A laddered CD portfolio (which isn’t the topic here) can help minimize the drastic ups and downs. I would say though that at this point rates are likely to go up at some point in the future, maybe late 4th quarter 2010 or early 1st quarter 2011. But since I don’t have a crystal ball, I like the ideas of adding some “complex” CDs.

Step-ups give you a known point where your CD rate increases. In an environment such as this, you can potentially purchase a little longer-term CD, but with the steps you’ll have protection against missing out on higher rates as the Fed increases Fed Funds. It is easier to find step-ups through brokers than direct. So far the shortest I’ve seen is around 12-years. They may have call dates where the bank can close the CD at a predetermined intervals.

Bump-ups allow you to move your rate up if the bank changes rates on the given term. So if you purchase a 3-year CD at 2.10% with a two-times bump option, you have the opportunity to move your rate up. If in 6-months the banks is offering a 2.50% for 3-years, you can move your CD rate up. Most Bump-ups don’t change the term, however as always, read all of the fine print. Before purchasing these type of CDs, ask the bank for some rate change history, especially in a rising rate environment. You want to make sure you will be treated fairly.

Finally, longer-term CDs with low penalties can be a good way to boost income without taking a huge amount of term-risk. If you find a 5-year CD rate around 3.50% and it has a 6-month penalty, your equivalent rates would be 1-year at 1.77%, 2Y at 2.63%, 3Y at 2.92%, and 4Y at 3.06%. All of those are at or better than you can find for the given term. So until rates rise you get a boost in income. If rates rise slowly, you maintain that boost. And if rates go up quickly you can close your CD, move to the higher rate, and not lose much. A great find with be a 7-year or 10-year CD with a 6-month penalty. I’ve seen some 10-year CDs advertised at 4.00%.

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