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Time is money.
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The Federal Open Market Committee has raised rates by five percentage points in its 2022–23 rate-hike regime, and expectations are that it’ll keep its benchmark rate relatively high for the foreseeable future. That’s good news for savers, and rates paid on certificates of deposit (CDs) have been given quite a boost.
Investing in CDs can be a relatively safe way to put some of your cash to work, even when the interest rate environment is less favorable for savers. There are strategies designed for any yield curve and to match your savings and income goals.
Key Points
- A laddered CD portfolio invests in varying maturity dates to create predictable cash flows and potentially earn higher yields.
- A CD barbell invests in two maturities—one long term and one short term.
- Sometimes you can find more attractive CD yields in the secondary market via brokered CDs.
Here’s how to invest in CDs and how to weigh the pros and cons to see which CD strategies make sense for you.
What are CDs?
Certificates of deposit are designed to hold cash for a set period of time while guaranteeing a yield. The issuing bank pays interest in return for you “locking up” your money, typically for a few months up to 10 years.
In general, you’re expected to keep the money in the CD through its maturity or face an interest penalty for early withdrawal. You’re rewarded for keeping your money in the account by being paid a higher yield on longer maturities.
Instead of depositing and withdrawing money whenever you wish, a CD is a “timed” account.
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Banks offer different types of CDs; they have various features, and some even offer the ability to “cash in” early without losing some of your paid interest (although your original yield might be lower). Investing in CDs can be one way to take advantage of rising rates without taking on the risk that might come with the stock market. CDs issued by banks that are members of the Federal Deposit Insurance Corporation (FDIC) are insured for up to $250,000 kept at each bank.
CDs are considered fixed-income investments. You receive interest payments at regular intervals, and you know how much to expect when you receive those payments. There are several different strategies you can use for investing in CDs, depending on your needs and the type of CD portfolio you’re looking for.
CD laddering
CD laddering is one of the first strategies that comes up when learning to invest in CDs. Creating a ladder can help you take advantage of long-term higher rates while providing some flexibility in your access to the money in your CD portfolio. Here’s how it works:
- Determine maturity intervals for your CDs. Figure out how often you want to receive interest and how often you want access to your money.
- Divide your cash into different CD maturities. For short-term goals, you might decide to divide your cash into CDs that mature every six months. For example, you might invest in four CDs that mature in 6, 12, 18, and 24 months. If you have a longer time horizon, you might decide on maturities of one-year intervals. For example, you might have $50,000 to create a long-term CD portfolio. You might consider putting $10,000 each into CDs with maturities of one, two, three, four, and five years.
- As the first CD matures, reinvest it into the longest maturity. Once the term comes to an end, you can decide what to do with the money. Maybe you need some cash. On the other hand, you could keep building your ladder for the future by getting a new CD with a longer maturity. For example, with a short-term approach, your first CD might mature in six months. At that point, you’d have CDs maturing in 6, 12, and 18 months. To keep the ladder going, you could invest in a new two-year CD.
CD barbell
Instead of including mid-length maturities, the barbell approach focuses only on short- and long-term maturities. You vary the percentages allocated to each side depending on the current interest rate environment. For example, in a lower-rate environment, you might be able to get CD rates that are higher than the yield you’d get in a savings or money market account, but still aren’t particularly attractive.
Savings accounts vs. CDs
What’s the difference? And where will you get the best bang for your safe investment buck? Compare savings accounts vs. CDs here.
However, as the rate environment changes, you might be able to take advantage of much higher yields on longer-term CDs, such as those with 5- to 10-year maturities. This approach allows you to access your money when the rate environment changes and boost your overall yield later.
Ladder and barbell strategies manage what fixed-income pros call duration risk. You can use these same strategies to maximize the return and efficiency of your fixed-income portfolio.
Including CDs in your IRA
The interest you receive from CDs is usually taxable in the year you earn or receive it. As a result, you typically need to report the interest—and pay taxes on it—as it accrues in your account.
One way to put off paying taxes on the interest is to keep your CD portfolio in an individual retirement account (IRA). Many banks offer so-called IRA CDs that are specifically designed to help you receive the tax advantages of traditional and/or Roth IRAs.
With IRA CDs, maturity rules still apply, and if you don’t reinvest the money after maturity, it could just end up as “regular” cash in the account (meaning you could lose out on the tax advantages). Additionally, if you cash in your CD before maturity, it’s still subject to early withdrawal penalties.
Brokered CDs
Rather than purchasing CDs directly from a bank, you might be able to get them through a broker. In this case, your broker shops around for attractive CD rates and offers them to you. If you have self-directed access to a brokerage platform, you can shop on your own.
These CDs might be newly issued (just like when you open an account at a bank), or they could come from the secondary market (if, for example, the owner of a CD wishes to sell it before maturity).
As with any CD, before you buy, make sure your investment is with an FDIC-insured institution. Also, make sure you check on the “callability” of a brokered CD. A callable CD frequently offers a higher rate than a non-callable CD with a comparable maturity date, but there’s a catch: It isn’t guaranteed to reach maturity. Typically, the issuer would redeem (“call back”) the CD if interest rates fall below the CD’s rate. That’s because the issuer can issue new CDs, with a similar maturity date, at a lower rate of interest.
Pros and cons of brokered CDs
| Pros | Cons |
|---|---|
| Access to a wider variety of maturity dates, terms, and the ability to sell your CD on the secondary market. | There might be transaction costs associated with brokered CDs. |
| Potential to more easily spread CD balances across different banks—particularly important if your assets exceed the $250,000 FDIC coverage. | There’s a potential for loss (market risk) if you sell your CD on the secondary market. |
| It can be easier to create CD ladders or add CDs to IRAs with the help of a broker. | If the broker uses callable CDs, you might lose out on some interest rate gains if the CD is called back before the expected maturity. |
The bottom line
Investing in CDs can be one way to get more out of the cash allocation in your portfolio. Your CD assets can work in tandem with the rest of your portfolio, providing you with a moderate level of liquidity in conjunction with relatively high yields when compared with other cash investments.
If you’re looking for a way to take advantage of higher rates while maintaining a degree of safety and liquidity, CD investing might make sense. Just be sure to understand the strategies and terms.
References
- Certificates of Deposit (CDs) | investor.gov
