As all savers know, interest rates have been unusually low for a very long time. The Federal Reserve (the Fed) lowered rates in response to the financial crisis in 2008, and kept rates low to encourage the recovery. In December of 2015, the yield on the 10-year Treasury bond was 2.24%. (Source: Standard & Poor’s) In that same month, the Fed raised rates for the first time since 2006. Savers everywhere rejoiced – hoping for a return to higher rates on savings. Since then, the Fed has raised rates 6 more times, including twice in 2018. (Source: Federal Reserve) As I write this, the yield on the 10-year Treasury is 2.89%, but the 30-year treasury yield is only a little bit higher, 3.06%.
People choose certificates of deposit for many reasons. They are convenient and easy to buy, available at just about every bank or credit union. CDs are generally simple and predictable, earning a fixed interest rate and maturing at fixed date in the future. They are available for various terms, and often have very low account minimums. They usually carry FDIC insurance (or NCUA in the case of credit unions) up to $250,000. (Source: FDIC, NCUA)
Here’s the bottom line: there are no perfect alternatives for CD buyers. Investments that are actually similar to CDs have similar interest rates. Things like Treasury bills, municipal bonds, corporate bonds and fixed annuities share many of the characteristics of CDs, such as fixed maturity dates and fixed interest rates. If an investment purports to be similar to CD, but carries a considerably higher interest rate, that’s a red flag. With fixed income investing, obtaining higher rates often means accepting lower quality or longer maturities, which may be contrary to the objective of a CD buyer.
Often, the first step CD buyers make in response to low rates is to increase the terms of their CDs. People who typically buy 1-year CDs might buy a 2-year CD if it pays a little better rate. Extending the maturity means that the money is tied up for a longer period of time, which may not be optimal.
If you have only invested in CDs throughout your life, be careful when making your initial foray into other investments. There will always be a tradeoff. If FDIC insurance is the most important thing to you, you may have to accept lower rates in to maintain that coverage. If generating income is the most important thing, you may have to forgo FDIC insurance.
While there are no perfect alternatives, municipal and corporate bonds may be appropriate. While bonds share some characteristics with CDs, such as a fixed interest rate and fixed maturity date, there are important differences as well. Bonds do not carry FDIC insurance, and interest and principal payments are based on the ability of the issuer to make those payments. Well-funded issuers will often be able to pay lower interest rates, while lower-rated borrowers may pay higher rates.
As with any investment, it is usually a good idea to do some research and obtain an understanding of the pros and cons before you commit to it. It may also be beneficial to obtain a second opinion by discussing it with someone you trust such as an attorney, a CPA, or a financial advisor. If something seems too good to be true, it often is.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Fixed annuities are long-term investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply.
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