By Bill Broich
Professional investors employ various strategies for CD investments to further reduce the risk and exposure to loss and improve liquidity. Consider your priorities and consult with a professional to determine the appropriate strategy for your unique situation.
Diversification: As with any investment strategy, diversification is a key to protecting your assets from risk of loss. Working with the different types of CDs that are available is yet another aspect of this strategy.
Market Linked CDs, which are tied to market indices, is an essential component of a CD diversification strategy. This provides you with different asset classes – international currencies, global investments, commodities, and also stocks and bonds – that will cover more bases in terms of risk protection from unpredicted changes in the economic landscape.
Studies on diversification show that investors who split investments into two or more different asset classes will receive on average the best possible total returns compared to those exclusively placed in a single asset class, and the longer the term of investment, the more consistent these results become. Working with Market Linked CDs is one of the only methods of blending FDIC insurance of principal with the diversification options available to investors in commodities, stocks, bonds, treasury bills, and international markets.
Laddering: The problem with many longer term Certificates of Deposit is the missed opportunity of locking in higher rates that may come available while an investor waits for their investment term to occur, and liquidity can be a problem as well. During periods where inflation is also rising, the risk of losing buying power increases.
The Laddering Strategy mitigates these issues by separating the total investment into multiple CDs with varying terms of maturity. For example, an investor that has 50,000 may put $10,000 each into a one-year, two-year, three-year, four-year, and five-year series of CDs. When the one-year CD matures, it is rolled into a five-year CD. This allows the investor to lock into a different type of CD investment or higher interest rates depending on how the economic climate changes from year to year.
With low interest rates holding steady in recent years, laddering does not currently provide opportunities for locking in increasing interest rates, but will still provide investors with liquidity.
Barbell Strategy: The Barbell Strategy emphasizes short and long term investments, for example, an investor may place a $50,000 investment of $25,000 each in 1 year and 5 year CDs. This may allow for better response to uncertain conditions that may arise in the coming years and maintain a higher level of liquidity than a standard laddering strategy.
Your CD maturity date is the date that your bank guarantees a full return of principal.
Liquidity is the investor’s ability to access the funds even if subject to a penalty or market value adjustment.
Investors who prize liquidity highly are concerned they will need money they have committed to a long term investment before it matures, but not all investments impose early withdrawal fees so investors need to be aware of the penalties specific to the products they are considering.
Market linked CDs are an example of the variables involved. While they may hold the CD to maturity, these instruments may be sold back to the issuing bank on a secondary market prior to maturity at a publicly displayed current market value.
Government bonds can behave in much the same manner, so both of these options are more liquid than other options that may have the same maturity date.
Investors receive higher interest rates for longer time commitments, but breaking that time commitment can often come with fees or penalties that eat into earnings and possibly even investment principal. Investors need to know penalties and fees that may come due well before they select a product.
Market Linked Certificates of Deposit and other brokered CDs require a custodial account and fees may be incurred for that account.
Investors should also be aware if the Financial Professional they are working with includes Certificates of Deposit in their “assets under management” account where a fee (i.e., 1%) is charged on all assets under the account. CDs are passive and do not require management, therefore they should not be included in such accounts.
Non-FDIC insured products may also have surrender fees, so investors must be aware of fees and penalties for all investment products they are considering.