This blog was originally written in February of 2024. It has been updated to reflect current figures and interest rates as of the new date of publication.
Lately, several people I’ve spoken to have asked me about whether Certificates of Deposit (CDs) are a sensible place to keep money in the current interest rate environment. The banking sector has certainly been banging the drum, offering the highest interest rates for short-term CDs in years, according to the wash of messages my own bank has deposited in my inbox. For our latest blog post here at Opus 111 Group, I thought it would be worthwhile delving a little bit deeper into CDs and whether they seem like a good choice now.
First, I should fully explain what exactly a CD is (hint: it’s not that thing you have a stack of gathering dust in the media room). A Certificate of Deposit is a savings product offered by banks referred to as a “time deposit account.” In essence, the bank promises you a specific return on your money, frequently expressed as an “annual percentage yield” (APY) in exchange for you depositing a sum of money and leaving it untouched for a specific period. The bank is then able to take this money and, knowing that they have access to its use for that period, go out and try to use it to seek a greater return than they have promised the depositor. If they can, they’ve potentially earned themselves a nice profit. Some of you by now may have drawn a comparison between a CD and a bond. While they have similarities, there are also a few key differences.
Generally, CDs are regarded as a more secure investment than bonds. While it is possible for a CD to lose money from its initial investment in the case of a very early withdrawal and subsequent penalty, bonds (especially those with longer maturities) are typically subject to a greater amount of volatility due to interest rate fluctuations and other market forces. As a tradeoff for this increased safety, the offered yields on CDs are often significantly lower than bonds. Per Bankrate, the average yield on a 1-year CD in the United States as of the writing of this article was 1.97%, while the 1-year U.S. treasury was 3.79%.
Most of the highest APY offers from banks are coming in the form of CDs that mature in less than one year. Banks still get to advertise the return they are offering on an annualized format, even if the maturity date is less than 12 months out. For instance, if a bank offered a 6-month CD with a 5% APY, a depositor may not immediately realize that the actual cumulative return of their CD at maturity midway through the year will be 2.5%. The only way the depositor will realize a full 5% return on their money over the course of the year is if they are able to obtain a second CD with an identical 5% APY when the first matures mid-way through the year.
This annualization of returns is not unique to CDs. U.S. T-Bills, which are issued in maturities between 4 and 52 weeks, also have an annualized coupon rate. It is critical for someone considering any debt instrument with less than one year to maturity that they understand what their actual return will be over the instrument’s duration. This becomes even more important in an environment where interest rates may drop. If rates are cut while holding a short-term CD, there is a very high likelihood that the depositor will not be able to find a new CD with a similar interest rate.
In the investment world, this is referred to as “reinvestment risk.” It hasn’t been a hot topic of discussion over the past few years because, in the historically low interest rate environment brought about by the Global Financial Crisis in 2007-09 and the COVID-19 Pandemic in 2020, real returns on many CDs and U.S. treasury income instruments (as well as a good portion of the bond market) were negative. Real return, in this case, is the interest paid less the rate of inflation, which ticked back upward in April, according to the Bureau of Labor Statistics.
Due to the relatively low risk of loss of principal (your initial investment), CDs are often described as “safe.” But CDs are exposed to a different set of risks, like reinvestment risk. There is the “inflation risk” that elevated levels of inflation may eat away at the real returns provided by these products. There is also a certain level of “liquidity risk” with CDs compared to cash, since it may not always be immediately possible to access the money in a CD in a timely manner—like if one needed to put in earnest money for a house in a competitive market, for instance. From our standpoint, the greatest risk a CD presents to a portfolio is what we call “underperformance risk.” Underperformance risk is the potential for overly cautious allocations within a portfolio to erode the ability of that portfolio to grow sufficiently to meet a client’s long-term needs.
The Verdict
Every investor’s individual situation is unique. The combination of their current financial circumstances and their short and long-term goals significantly changes how we approach managing their portfolio in pursuit of accomplishing all they’ve set out to achieve. That said, I think there are a few key questions to ask yourself when considering a CD:
Am I highly confident that I won’t need this money before the CD matures? (Liquidity Risk)
What will my cumulative return be, specifically over the period until maturity of the CD itself? (Inflation Risk)
Does it seem likely that I’ll be able to get a CD of a similar interest rate when this one matures? (Reinvestment Risk)
Am I okay sacrificing the potential for greater returns elsewhere in exchange for the security of knowing my investment is highly unlikely to decrease in value? (Underperformance Risk)
If the answer to all four is “yes,” then I believe a CD can make sense. The hypothetical scenario that springs to mind is someone with a known liquidity need after the CD will mature, but still less than one year.
If the answer to one or more of those questions is “no,” however, then it may make sense to consider an alternative. Your financial advisor can be a good resource to help you better understand the various forces at play and arrive at the decision that is right for you and your portfolio. As always, I welcome you to reach out to our team with questions and concerns—we are here to help you!
Andrew Harvey, CPWA®, AIF®, CPFA™ is the Chief Operating Officer and a Financial Advisor at Seattle-based Opus 111 Group. He created Opus 111 Group’s SYFI (Secure Your Financial Independence) Program for young investors in 2022 and works in Opus’ Retirement Plan Consulting Division. In his spare time, he plays the Irish sports of hurling and Gaelic football for USGAA side Tacoma Rangers. Andrew lives in Kent, Washington with his wife Lauren and their cats, Bella and Leeloo.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation. All investments are subject to risk of loss.
Certificates of deposits (CDs) typically offer a fixed rate of return if held to maturity, are generally insured by the FDIC or another government agency, and may impose a penalty for early withdrawal.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.