For the longest time, fixed income options from your bank or the broker-dealer you invest through were far from appetizing. For the last 7 years, equities were on a tear. We were in the longest bull market of our country’s history. Investors in the accumulation phase who were invested for growth, rode the equity wave higher and higher. This even includes the brief retreat in spring of 2020 which simply spurred on even greater bullish attitude to close out that year. For investors who were reaching the end of the accumulation phase and did not want to take on the risk that is associated with a primarily equity-based portfolio, bonds were an important piece of the puzzle coupled with fixed annuities and Government Securities. All of these pieces have their place in a financial plan. One such piece that I did not mention are Certificates of Deposit. I’m sure you have heard of C.D.s, but probably do not know anyone who owns one under the age of 65. For good reason, investors in recent years shied away from utilizing this security because they lock your money up for a certain amount of time and they were offering interest rates comparable to money market or checking accounts. The need for short-term fixed income is always present, but investors were less than thrilled with the prospect of these securities. Fast-forward to the second half of 2022 and the first quarter of this year and C.D.s have made a stunning comeback! Why is this the case and what do they offer that could be of benefit to you?
A Brief History
The idea of a certificate of deposit or a term deposit account is not a new one. C.D.s first began being used in the 1600s by European banks. The concept then is the same as now, you deposit your money in the bank and if it is held for a certain amount of time, you will have earned a certain amount of interest. It is a simple concept. On our side of the pond, C.D.s really started to gain traction as the U.S. banking system started to formulate in the late 1800s. People were looking for safe places to put their money and C.D.s at the bank were seen as the avenue to do that. Sadly, since these accounts were not protected from bank failure until 1933, misplaced faith in the banking system led to many families losing everything in 1929 with the stock market crash and resulting Great Depression. This of course included money that was invested in C.D.s. The creation of the FDIC in 1933 jumpstarted the recovery of public trust in banks and allowed for C.D.s to become popular again. Stock market distrust, spurred on by pain felt from earlier generations, led C.D.s to become very popular. By the end of the 20th century those who had reservations about the stock market utilized these savings vehicles to receive a return on their savings without the risk of loss that comes with market volatility. As of late, C.D.s were not offering interest rates that made them attractive to savers.
Because of historically low interest rates, Certificates of Deposit were hardly paying anything throughout the 2010’s. Federal interest rates have a direct correlation with the rates that your local bank will be offering on a C.D.. As the Federal reserve dropped rates throughout the 2010s following the recession of 2008, C.D. interest rates dropped as well. The government was spurring economic growth rather than encouraging people to sit on their money. How about recently? The Fed is using their primary tool to fight raging inflation in this country. That tool is raising interest rates. What does this do? Higher interest rates discourage people from borrowing money and thus decelerates the influx of new dollars into the money supply. What else does this do? It encourages people to save! High interest rates means that loans and mortgages will carry higher interest debt. Higher rates also mean higher rates for saving vehicles like C.D.s. What are some practical ways that C.D.s could be used by someone who is also actively investing in the stock market?
Why use a C.D.?
The high interest rate environment that we are currently in has pushed C.D. rates up to 5% or even higher from some banks. If you have savings that you need to use within a certain number of months or years, a C.D. could be a great option. Let’s use the example of buying a house. You have money invested in the market in your employer retirement plan and your personal Roth IRA but you also have money saved in a savings account for a down payment on a future home purchase a year from now. Let’s say you have $40,000 saved up that you want to be earning more interest on than a savings account, but don’t want to risk losing any principle. A guaranteed fixed-rate could be a good option. If you were able to get a 5% 1-year C.D., you your $40,000 would gain $2,000 of interest and you would have cash of $42,000 without additional deposits or stock market risk. C.D.s do of course lock your money up for the specified period of time that it takes for them to mature. Choose maturities wisely when considering the fact that the cash will not be available to you. C.D.s can be used for any situation in which you have a set amount of cash saved that you know you will need within a certain time period, but that you don’t need to use now AND that you want “risk-free” returns on. (C.D.s are FDIC insured so they are backed by the U.S. government and deemed “risk-free”).
In the past Certificates of Deposit were an afterthought because their rates were not competitive. The reward matched the risk level which is zero. Now as rates rise, the reward is growing while the risk remains level. C.D.s are much more attractive than they were before and should be seriously considered in part of your financial plan. Thanks for reading today! As always, please share this blog with anyone whom you think may be interested. We appreciate your support and feedback.
See you next week!