Certificate of Deposit

What is a Certificate of Deposit?

A certificate of deposit, or CD, is a predominately fixed rated savings vehicle for investors who do not need to immediately access their cash.  CD's are issued by major banking and other S&L institutions & carry a guarantee of $100,000 if they are issued by FDIC insured institutions.  A borrowing institution who is not FDIC insured must offer the investor with a higher yield to compensate for the added risk. 

Customers lend money to these financial institutions for a pre-determined amount of time and at a predetermined interest rate, unless the CD is variable rate, which is not common. 

CDs & the Yield Curve

Depending on the structure of the yield curve, short term CDs may actually have a greater interest rate than a longer term CD.  However, an inverted yield curve is not a very common occurance.  In most cases, the longer the duration of the CD, the higher the interest rate that the customer will receive. 

Jumbo CD's

It is also common for CD yields to move higher when larger deposits are made.  CDs can become Jumbo issuances when they are created with an amount of more than $95,000.  Some banks will have a minimum of $100,000 to be considered jumbo.  Jumbo yields must be higher in part due to the added risk of FDIC insurance not being available on amounts above $100,000.

Types of Cd's

There are a few different types of certificates of deposit which can be offered to you by your financial institution.  Let's cover each one, understanding the different features of each.

Traditional CD's 

Traditional CD's will be at a fixed rate over the life of the CD.  Depending on the CD, periodic interest payments may be re-invested into the CD which will allow for interest on interest compounding.  Check with your bank when you get into the CD.

Callable CD's

A callable CD, similar to a callable bond, gives the issuer the opportunity to redeem the CD before the maturity date in the case that prevailing market interest rates move lower.  The bank will return the initial investment plus any interest owed.  This type of CD will have an embedded premium in its APY to compenstate the buyer for the risk of this occuring.

Zero-Coupon CD

Similar in concept to the zero coupon bond, zero-coupon CD's make no periodic interest payments and are issued at a deep discount to par value.  Structurally, zero coupon CD's automatically re-invest the interest payments back into the CD to be able to allow you to redeem the CD at par.  There is one issue with these bonds, they generate a taxable event even though they do not issue interest payments each year.  Consult with your tax advisor if you are interested in zero's

Liquid CD's

Liquid CD's provide you with the ability to withdraw funds from the CD without a penalty under certain conditions.  Most CD's will stipulate that you must maintain a minimum balance to do this.  Yields will obviously be lower than the Traditional CD due to the inability of the bank to lock your cash in for a fixed period of time.  Additionally, there may be a cap on the number of times that a withdrawal is allowed per year.  Understand the rules if you plan on buying a Liquid CD.

Bump Up

A bump up CD can be viewed as the opposite of the callable CD.  It allows the investor to actually move into a higher yielding CD once during the life of the CD, if the opportunity presents itself.

Brokerage CD

A brokered CD is nothing more than a CD offered by a brokerage house.  They offer more liquidity and higher rates than bank CD's due to the fact that they are traded in the secondary market.  However, trading CD's will open you up to CD price shifts and may result in a principal loss. 

It is very important for the investor to research which CD that the brokerage house is putting you into; remember, some CD's are not FDIC and open you up to risk.  Secondly, some brokers will pool investor funds into one bucket and buy the CD under their umbrella.  You want to make sure that each owner within the CD has their own title and ownership interest in the CD.  This way, in the event of a failure, you will guaranteed the $100,000 insurance from the FDIC.
Tim Ord
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